Financial Markets and Institutions (2-downloads)

www.amatecon.com/

greatdepression.html

. This site contains a brief dis-

cussion of the factors that led to the Great

Depression. Write a one-page summary explaining

how adverse selection and moral hazard contributed

to the Great Depression.

---

Why Do Financial Crises

Occur and Why Are They So

Damaging to the Economy?

Preview

Financial crises are major disruptions in financial markets characterized by sharp

declines in asset prices and firm failures. Beginning in August of 2007, defaults

in the mortgage market for subprime borrowers (borrowers with weak credit

records) sent a shudder through the financial markets, leading to the worst U.S.

financial crisis since the Great Depression. Alan Greenspan, former Chairman of

the Fed, described the 2007–2009 financial crisis as a “once-in-a-century credit

tsunami.” Wall Street firms and commercial banks suffered losses amounting to

hundreds of billions of dollars. Households and businesses found they had to

pay higher rates on their borrowings—and it was much harder to get credit.

World stock markets crashed, with U.S shares falling by as much as half from

their peak in October 2007. Many financial firms, including commercial banks,

investment banks, and insurance companies, went belly up. A recession began

in December 2007. By the fall of 2008, the economy was in a tailspin.

Why did this financial crisis occur? Why have financial crises been so preva-

lent throughout U.S. history, as well as in so many other countries, and what

insights do they provide on the current crisis? Why are financial crises almost

always followed by severe contractions in economic activity? We will examine

these questions in this chapter by developing a framework to understand the

dynamics of financial crises. Building on Chapter 7, we make use of agency the-

ory, the economic analysis of the effects of asymmetric information (adverse selec-

tion and moral hazard) on financial markets and the economy, to see why financial

crises occur and why they have such devastating effects on the economy. We will

then apply the analysis to explain the course of events in a number of past finan-

cial crises throughout the world, including the most recent subprime crisis.