An economic downturn caused by a shock in the financial markets may define a financial crisis. This shock is usually the collapse of an economic bubble, which may be found anywhere from the real estate markets and stock markets to the labor markets. Following a bubble's collapse, the main elements and effects of a financial crisis include bank panics, credit crunches and a recession.
The cause of an economic bubble is when the price of a group of assets is much higher than their actual worth. Increase in pricing is a result of an increase in purchases for that given asset. It is known as a "bubble," as it is generally thought that it will "pop" once the markets receive some kind of economic shock. An example of this includes the sub-prime mortgage crisis of 2006 when the price of housing was relatively high with respect to its value. When people defaulted on their mortgages, prices crashed due to the large increase in selling. Other bubbles in history include the dot.com bubble in the 1990s due to the over-investment in dot.com stocks. When these companies began posting losses, their stock crashed.
Bank runs may further exacerbate the negative effects of a financial crisis. When a bank's customers lose confidence in the bank's ability to pay back their deposits, a bank run may occur. One characteristic of a bank run is the sudden and dramatic increase in the number of people wishing to close their accounts. Bank runs tend to be a result of social panic, as the bank is usually able to repay customer deposits if need be. This is because the government usually insures the banks. However, bank runs have a negative effect on banks as it leaves them with little liquidity to invest. Hence, a bank that suffers from a bank run will find it more difficult to provide loans and mortgages.
A credit crunch, or credit squeeze, is when financial institutions become reluctant to lend money. This may be a result of a bank run, but it is more often due to a lack of investor confidence. During the financial crisis that began in 2007, banks were cautious about granting mortgages as the performance of current mortgages was declining. As banks became afraid of further falls in profits, most investments required some form of credit. Hence, investment declined, which in turn affected the economy's rate of growth. Interest rates also rise as banks feel the need to make up for the increased risk they are taking on with any new investment or loan.
Negative economic growth generally defines a recession. A financial crisis is one factor that may cause a recession, primarily by means of a fall in investment. A fall in investment may also lead to a fall in employment, as new investments require new employees. Falls in employment lead to a fall in consumer expenditure. This has a negative effect on the economy, as consumer expenditure is usually the largest contributor to economic growth. A fall in consumer expenditure dents company profits, which leads to further unemployment and a fall in stock prices. Although the cause of many recessions is a financial crisis, note that not all financial crises lead to a recession.
- U.S. Department of State, Foreign Press Centers; CRS Report for Congress -- Averting Financial Crisis; Mark Jickling; March 2008
- Library of Economics and Liberty; The Concise Encyclopedia of Economics, 2nd edition -- Bank Runs; George G. Kaufman; 2008
- The Times; The Credit Crunch Explained; David Budworth; January 2010
- The National Bureau of Economics Research: The NBER's Business Cycle Dating Committee
- Board of Governors of the Federal Reserve System; Asset Bubbles, Domino Effects and 'Lifeboats': Elements of the East Asian Crisis; Hali J. Edison, et al.; March 1998