Financial crisis
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A financial crisis is a situation when money demand quickly rises relative to money supply. Until a few decades ago a financial crisis was equivalent to a banking crisis. Today it may also take the form of a currency crisis. Many economists have come up with theories on how a financial crisis develops and how it could be prevented. There is, however, no consensus and financial crises are still a regular phenomenon. A stock market crash is an example of a financial crisis.
[edit] A Cyclical theory of financial crises
Hyman Minsky has proposed a simplified explanation that is most applicable to a closed economy. He theorized that financial fragility is a typical feature of any capitalist economy. High fragility leads to a higher risk of a financial crisis. To facilitate his analysis Minsky defines three types of financing firms choose according to their tolerance of risk. They are hedge finance, speculative finance and Ponzi finance. Ponzi finance leads to the most fragility.
Financial fragility levels move together with the business cycle. After a recession firms have lost much financing and choose only hedge, the safest. As the economy grows, and expected profits rise, firms tend to believe that they can allow themselves to take on speculative financing. In this case they know that profits will not cover all the interest all the time. Firms, however, believe that profits will rise and the loans will eventually be repaid without much trouble. More loans lead to more investment and the economy grows further. Then lenders also start believing that they will get back all the money they lend. Therefore they are ready to lend to firms without full guarantees of success. Lenders know that such firms will have problems repaying. Still, they believe these firms will refinance from elsewhere as their expected profits rise. This is Ponzi financing. In this way the economy has taken on much risky credit. Now it is only a question of time before some big firm actually defaults. Lenders understand the actual risks in the economy and stop giving credit so easily. Refinancing becomes impossible for many and more firms default. If no new money comes into the economy to allow the refinancing process, a real economic crisis begins. During the recession firms start to hedge again and the cycle is closed.
[edit] Contagion
In a modern open economy a country's finances are often dependent on international development. Contagion is the idea that a financial crisis in one country is very likely to cause a crisis in another. An example would be the Thai crisis in 1997. Then a foreign investor would become suspicious of the stability of any other not sufficiently developed economy and would decide to withdraw his or her money from such a country. This causes a sudden stop of funds for many economies and thus more financial crises. The interesting fact here is that firms in a stable economy, e.g. South Korea, would be denied financing simply because another economy in the region is failing.
