Financial crisis

A financial crisis occurs when the value of a financial institution or an asset drops very quickly. Financial crises, which are sometimes referred to as "economic downturns," are often associated with panic as investors, fearing that the value of their assets will drop if they remain at a particular financial institution, sell off assets or withdraw money from banks. If a financial crisis is prolonged and occurs over several months, it can lead to a recession or a depression. The main differences between a recession and a depression are the length of time for which it occurs, the severity, and the impact it has on the economy and population as a whole. A recession indicates a significant decline in economic activity lasting more than a few months, while a depression, which is generally more severe, usually lasts much longer.

Background

Financial crises have occurred throughout history, with some dating as far back as 1720, and they have ranged in severity and length. The worst financial crisis ever to hit the United States is known as the Great Depression, which lasted from 1929 to 1939. It was the deepest and longest-lasting economic downturn in the history of the industrialized Western world. The Great Depression began in the United States shortly after the stock market crashed in October 1929. The crash sent Wall Street into a panic and wiped out millions of investors. Consumer spending and investing dropped, which then caused sharp declines in industrial output and higher unemployment levels as failing companies were forced to lay off employees.

By the time the Great Depression hit its lowest point in 1933, roughly 13 to 15 million Americans were unemployed, and nearly half the banks in the country had failed. President Franklin D. Roosevelt put relief and reform measures into place, which helped lessen the worst effects of the Great Depression as the 1930s continued. It was not until World War II kicked American industry into high gear in 1939, however, that the economy was able to see a full turnaround.

After the Great Depression, the United States remained relatively financial crisis–free until the 1970s, after which an average of one crisis per decade has occurred. During the oil crisis of 1973 and 1974, the collapse of the Bretton Woods currency system, combined with an embargo imposed by Arab oil exporters, resulted in a slump felt across the Western world. In 1987, the stock market crash on Black Monday—October 19—sent the world into a financial crisis. The effects of the Asian crisis in 1997, when a stock market crash shocked markets throughout Asia, were felt in the United States, and markets took a significant hit. A "dot-com boom" in the late 1990s occurred when shares in Internet firms rose amid excitement over the World Wide Web, but in 2001, the dot-com crash occurred when investors spotted a lack of profits in these companies.

In 2008, the "Great Recession," which was the worst financial crisis to affect the United States since the Great Depression, began. The period encompasses both the recession in the United States, which officially lasted from December 2007 to June 2009, and the ensuing global recession in 2009. The economic downturn began when a boom in the housing market in the United States went bust. The housing crisis of the mid-2000s was the result of mortgage lending operations at many banks across America. These operations had approved loans for subprime borrowers with poor credit histories. These borrowers then struggled to repay their loans, which resulted in a high number of foreclosures. Thus, housing market became flooded, which led to a slump in housing prices. Like the Great Depression, the Great Recession caused banks, such as Lehman Brothers, to fail and led to high unemployment levels.

Overview

No two financial crises are the same, and several unique factors can lead up to and cause an economic downturn. The crisis in the early 1970s, for example, was primarily caused by an oil embargo enacted by members of the Organization of Arab Petroleum Exporting Countries as a result of the United States' show of support for Israel during the Yom Kippur War. Although each financial crisis has unique factors, many crises have some similarities. Factors that can lead to a financial crisis include

• high interest rates;
• inflation;
• reduced real wages; and
• reduced consumer confidence.

High interest rates can cause a financial crisis because they limit liquidity, or the amount of money available to invest. This is why the federal government, particularly the Federal Reserve, takes much blame when a financial crisis hits. The Federal Reserve sets interest rate levels depending on economic performance and strength.

Inflation, which is the rise in prices of goods and services over time, also plays a role in the development of a financial crisis. As inflation increases, the percentage of goods and services that can be purchased with the same amount of money decreases. Thus, businesses are not able to sell as many goods because consumers do not have the money to purchase them.

Real wages are wages adjusted for inflation—in other words, wages in terms of the amount of goods and services that can be bought. Reduced real wages result when workers' paychecks cannot keep up with increased inflation levels. Consumers might be making the same amount of money, but as the cost of goods and services increases, their buying power decreases.

The effects of increased inflation can lead to reduced consumer confidence, which can be a contributing factor to a financial crisis. If consumers believe that the economy is in bad shape, they are less likely to spend money and more likely to save in case the market crashes or they lose their job. Although it is psychological, consumer confidence can majorly influence the economy.

Bibliography

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