Financial crises occur when relatively large groups of people panic in a financial market, disposing of assets in order to meet payment obligations, or in response to the threat of a financial institution becoming insolvent, or the threat of an asset market collapse. They tend to occur during recessions in the short cycle in the context of long-wave downswings (for example, in the 1970s–1990s), when instability and uncertainty are higher than average. They are usually precipitated by spectacular bankruptcies. Wolfson (1994) has produced the most detailed political economy view of financial crises, through an examination of the crises of 1966, 1970, 1974, 1980, 1982, 1984, 1987 and 1991 in the USA. His work links the work of institutionalists, post-Keynesians and Marxists.
Mishkin, a more traditional economist, defines a financial crisis as “a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities” (Mishkin 1992:117–18). Adverse selection occurs when clients with a bad credit risk are more likely to be selected to borrow money; moral hazard occurs when there are incentives for borrowers to engage in risky projects in which the lender bears most of the cost if the project fails. In Mishkin’s analysis of financial crises, typically a combination of increases in interest rates, a stock market decline and an increase in uncertainty cause adverse selection and moral hazard to increase and GDP to decline. This then leads to a “bank panic,” which worsens adverse selection, moral hazard and GDP. During very difficult times, such as during the GREAT DEPRESSION, this may additionally lead to a debt-deflation process (see Fisher 1933), with a declining general price level and greater uncertainty.
Financial crises, along with DEBT CRISES IN THE...