A financial crisis occurs when the value of a country’s financial assets drops rapidly. The crisis is often associated with bank runs, investors panic, and massive withdrawal of funds from the banking institutions. These scenario foretells that everything is going downhill – hence, the need to withdraw all savings and investments from all financial sectors.
When assets are deemed overvalued, rapid sells-offs occur that leads to a financial crisis. If left unchecked, the situation can further lead to a decrease of assets values and the massive withdrawals by investors. The outcome is mass hysteria that makes the economy to go under towards recession or depression.
The economy is on a tailspin if:
- There is a significant drop in the housing sector;
- A surge or increase in the numbers of jobless;
- There is apparent decline in economic output.
Investments can be affected if the financial markets go into a nose dive. Recession always comes after a peak in the business cycle is achieved. There is decline in earnings and employment after every expansion. Recession occurs when this scenario happens with wages and prices of goods remaining the same as in the peak period.
This then leads to a declining economy that results to a trough or depression. The length of time of the trough is critical since it determines the gravity of employment and economic output bottoming out, while waiting for the next cycle of recovery to begin.
World’s Financial Markets on a Tailspin?
All global central banks are in panic mode by the 4th quarter of 2013. All the world’s economies assessed the situation as bleak and embarked on strategies for damage control. The big story about the bubble burst centered on China’s interbank liquidity problems and overnight rates that are spiraling upward.
China’s stock market is now in a free fall and has fallen by 20% at present. The Central Bank of China tried to appease investor confidence by assuring the market that there is liquidity in the banking sector. But the market did not react and investors became wary despite of assurances from China.
In the United States, there were acrimonious debates about the Fed’s ability to control Quantitative Easing (QE) by late 2013 to the middle of 2014. Based on historical data, the Fed had miserably failed to spur economic growth. It had only managed to create stock market bubbles while draining the financial markets of high quality collateral instruments.
The leverage situation today is worse than that of 2008 due to Fed’s intervention. However, as seen in recent weeks, the bond and stock reaction to Fed’s market intervention is critical; and if it backs off support – the entire system may be at risk.
With the collapse of the bond markets in Europe, there is the fear that what would come next are higher interest rates. This new emerging market scenario is catastrophic with all economies in the world frozen in a debt bubble. The world’s central banks can only watch, while they lose control of the financial markets. The emerging scenario looks bleak with industry stalwarts saying that the situation may be worse than what happened in 2008.
The Economic Bust in 2007 and 2008
What transpired in this two year period may be akin to the pre – Federal Reserve era. The market was in a state of panic with people divesting their assets thereby driving prices down to unpredictably low levels. What happened then, were people getting out – all at the same. time. The mass hysteria affected short term instruments like repos, bonds, stocks, commodities, and real estate.
The wave of terror not only affected short term investments but long term instruments as well. This worldwide debacle caused the collapse of bedrock companies like Merrill Lynch, Lehman Brothers, Bear Stearns, Washington Mutual, Wachovia, and Countrywide Financial.
The next financial crisis is expected to be the same as what happened in 2008, 1987, 1929, 1907 and so on. The bank run will be systemic, credit will freeze, great number of people lose their jobs, and millions of people will have their lifetime savings decimated. It happened in the 19th century when the central banks were still non-existent, and didn’t stop even after the appearance of the Fed in 1913.
There is no triggering factor that would determine if the crisis had started. Depositors in banks like Wells Fargo, Citibank, and Bank of America did not panic to alert the nation. It was the Fed who took notice that the major banks were under-capitalized, over leveraged, and insolvent before it came in with a bailout package.
The 2007-2008 economic debacle affected the stock market when it realized that the banking community did not have the resources to absorb the run. What transpired was a lack of confidence in the stock market that made it suffer immensely. What saved the day was the guarantees made by the Fed and the Treasury on the stock markets, that it would guarantee bank deposits of up to $250,000 and inject billions of capital to save the country from total financial collapse.
It has been discussed most seriously at present that to save the financial markets from future runs, there should be sufficient capital or fortress funds to meet its obligations from the run. Losing confidence on the banks and lenders pulling out their funds from one or more banks can be disastrous on the banking system. The continued incoming streams of short term funds are needed by banks to meet their long term obligations. Without this continuity, it would be inevitable for another bank run to begin.
Can The Global Economy Handle Another Financial Crisis?
It has to be reiterated that the world economy is connected than many pundits believed. While it is important to be aware of how the U.S. economy is faring, it is still part of the global economy where many players are positioned at the top. China had become one economic dragon to rival that of the U.S. for top position. China has the presence in many parts of the global economy that include commodities and the material sectors.
The more recent moves by China in shifting from an outward driven economy towards its domestic markets is causing significant problems with its trading partners. The Gross Domestic Product of China is watched most carefully since the global arena is heavily dependent on its rapidly rising economy. Financial debacles in China are observed keenly by global markets, since its downfall could wreak havoc in all of the world’s economies