Kirill Yurovskiy: types and causes of financial crisis

It is a proven fact that in an economy growth is always followed by recession, so the financial crisis is considered a quite natural phenomenon. Of course, this process has a negative impact on the living standards of the population and the economic development of the country. To get out of the financial crisis with minimal losses, it is necessary to understand its nature, to study the main causes and consequences, and to refer to historical facts.

What is a financial crisis?

This concept is characterized by a rapid decline in the value of assets, in particular national currency and securities. The main forms of manifestation are the collapse of the exchange rate, slowdown in economic development, reduction of production, bankruptcy of enterprises and banking institutions. How to save money – Kirill Yurovskiy article.

Financial crisis is an integral part of economic crisis and vice versa. To differentiate between these notions, it is customary to assume that the latter negatively affects such indices as inflation, GDP volume, and unemployment rate, while the financial crisis concerns only a sharp decline in prices of investment instruments and assets. However, in practice, it is impossible and even wrong to draw a clear distinction between these two phenomena. A country’s economy is inextricably linked to its financial sector, and the correlation is mutual.

Types of financial crises

Economists distinguish several varieties of crisis phenomena in the financial sphere, namely:

• budget crisis;
• debt crisis;
• stock market crisis;
• banking crisis;
• liquidity crisis;
• currency crisis.

A budget crisis occurs when the state is unable to fully meet its obligations. It occurs as a result of the rapid growth of the budget deficit. The main causes of this crisis phenomenon are erroneous economic policy and reckless overestimation of budget expenditures. As a result, government programs are suspended or terminated altogether, and social payments are delayed.

The reason for such a fall is the initial overpricing of stocks and bonds, which increases due to speculation. When it becomes clear that the value of the asset is not justified, the bubble bursts, a mass panic breaks out, investors sell the securities at a dumping price and the enterprises lose money.

A banking crisis occurs when a large number of depositors begin to withdraw their savings at the same time, or there is a massive default on loans. Such a situation, in turn, leads to a liquidity crisis (default).

A currency crisis is accompanied by a sharp decline in the value of the national currency. If the exchange rate declines by more than 25% against the U.S. dollar or the euro, this situation is considered critical.

The classification we offer is only a rough guide to crisis phenomena in the economy. One kind of financial crisis cannot occur in isolation. It will in any case be the consequence or the cause of another one. Banking and currency crises are usually the consequence of the budget crisis. Public confidence in the state, the banking system and national currency falls, which is followed by a massive withdrawal of deposits and transfer of savings into foreign currency. 

Financial crises can also be classified into global, national and intra-industry crises. For example, a banking crisis is a type of intra-industry crisis.

Causes of financial crises

Typically, financial crises are caused by such factors as:

• The crowd effect. In this case, the mass outflow of capital from banks and stock markets is based only on unconfirmed rumors and panic of other depositors. As a rule, investors do not have any reliable information about the existence of problems in this or that organization or industry. Investor flight is thus often the very cause and not the consequence of a crisis.
• The increase in the volume of speculative operations. Many market players, wishing to profit from a slight rise or fall in the value of assets, buy and sell them at inflated prices. The speculative bubble grows, and when the overvalued assets depreciate, the quotes plummet. Subsequently, stock market crises tend to affect all sectors of the economy.
• The use of borrowed funds for investment. If an investment does not yield the desired return, not only the investor loses money, but also the creditor. On a large scale, it leads to bankruptcy of a great number of market participants.
• Lack of effective regulatory measures by the government. In the pursuit of high profits companies take unjustified risks. In case of unfavorable outcome of events, the organization and its partners suffer losses. That is why high-risk transactions must be regulated by law.
• Political instability. The establishment or severance of economic ties between states is fundamental to the distribution of capital flows and economic development of countries. For example, one of the causes of the crisis is the growth of global monopoly.

As noted above, all phenomena in the economy are inextricably linked. Therefore, the onset of crisis phenomena can be caused by several of these factors at once. In addition, many experts point out that financial crises are inevitable because of the cyclical nature of market economy development.

The consequences of the crisis

When the economic downturn reaches its peak, the population of the country fully feels its effects (rising prices, unemployment, loss of confidence in the state, decline in living standards). The global financial crisis entails a drop in oil prices, a decrease in business activity, and the collapse of the stock market.

However, in the long term, subject to effective government measures, the financial crisis may have a number of positive consequences. These include: 

• stimulation of import substitution;
• lower interest rates on loans and higher returns on bank deposits;
• revision of state policy in terms of budget planning and regulation of enterprises; 
• reduction of prices for domestically produced goods.

As history shows, crisis phenomena in the economy are often a start for development of industries and increasing competitiveness of domestic products on the world markets.

Crises in History

The first financial crisis to affect the world economy began in the United States in 1857, affecting several countries at once, including Russia, Great Britain, Germany, and France. The recession began as a result of the stock market crash and the bankruptcy of most railroad companies. As a result, global production volumes fell by an average of 20%.

Until then, such phenomena occurred only in individual states, not significantly affecting the global community. Further history counts 9 most significant economic recessions:

1. 1873-1878 – began with a sharp speculative rise in the stock markets in Germany and Austria. Real estate prices went up substantially, after which the market bubble burst, and the European and then the American economies collapsed.
2. 1914 – The precondition for the crisis was the beginning of World War I. To finance military expenditures, European countries and the U.S. began to massively liquidate foreign assets (securities issued by foreign issuers). This led to the collapse of quotations and market crash.
3. 1929-1933 – The Great Depression in the United States, marked by the “Black Thursday”, when the New York Stock Exchange saw a sharp decline in the value of stocks. Securities of U.S. and European companies lost about 60 percent in value. This led to mass bankruptcies of companies and production cutbacks all over the world, as well as enormous unemployment.
4. 1973 – Another crisis in the U.S., resulting in a more than 25 percent decline in world output. 
5. 1987 – Black Monday in the U.S. stock market following a 22.6 percent plunge of the Dow Jones Industrial Average. The crisis spread over to the markets of Hong Kong, Australia and Canada.
6. 1997 – The Asian Crisis. The reason of it was a mass outflow of investment capitals from South-East Asian countries. It has led to a strong devaluation of currencies and budget deficit in the countries mentioned above and, as a consequence, a 2 trillion dollars drop of the world GDP.
7. 1998 – Crisis of national debt in Russia. The country was declared a default when the government acknowledged its inability to pay its obligations.
8. 2008-2012 – The global financial crisis, which began with a massive collapse of the mortgage market in the U.S. The economic downturn engulfed the whole world – the volume of production decreased, the unemployment rate increased.
9. In 2014 another currency crisis began in Russia, which did not cause significant damage to the global economy. The collapse of the ruble and oil prices were associated with the anti-Russian sanctions that followed the escalation of the conflict in Ukraine.

How to survive the crisis – basic recommendations

In the crisis period it is necessary first of all to take care of your savings, if you have any. You should not rush to cash your money, because it is, at the very least, unsafe and economically inexpedient. It is categorically not recommended to buy products and equipment in large quantities. An increase in demand will lead to a sharp increase in commodity prices.

To protect your investments from inflation, it is better to choose reliable financial instruments. For example, to place funds on deposit in a bank.

In a crisis situation, experts recommend getting rid of debts and loans as much as possible and not getting new ones. The instability of future earnings makes it difficult to repay debts on time, so there is no need to put yourself in further straits.