Financial Crises: An Introduction

A financial crisis is “a disturbance to financial markets, associated typically with falling asset prices and insolvency among debtors and intermediaries, which spreads through the financial system, disrupting the market’s capacity to allocate capital”

 (Portes & Swoboda, 1987: p10)

Throughout history there have been numerous financial crises that vary in strength and location. The most notable financial crises include the great depression in the US (1929), the oil crisis in 1973, the Asian financial crisis (1997), the bursting of the dot com bubble (2001), the financial crisis of 2007-2010 and most recently the European debt crisis (2010).

In a financial crisis the economy goes through a series of stages, Kindleberger (1989) defined these stages as follows:

Stage 1: Displacement: Displacement occurs when there is an outside shock to the economic system which modifies the outlook of the economy

·       In the case of the 2007-2009 financial crisis the shock was the slashing  of short term interest rates to 1% by the Federal Reserve- aimed at stimulating growth in the sluggish economy

Stage 2: Boom/Credit Expansion: These low interest rates stimulated a boom in housing as mortgages were cheaper to attain. This boom increased house prices and construction rates raised to satisfy demand

Stage 3: Bubble/Mania:  A large proportion of the population became involved in the housing boom and segments of the population usually not included become involved, for example, sub-prime mortgage holders.       This led to speculation for profits and rationality gave way to irrationality and mania

Stage 4: Distress: In the US interest rates began to rise, leading to a fall in house prices and many sub-prime mortgage holders were unable to meet repayments. At this stage the bubble begins to unravel

Stage 5: Crash and Panic: System unstable and close to crashing. Panic was triggered by the failure of many financial institutions for example that of Lehman Brothers in 2008

The graph below illustrates the movement in the interest rate in the US between January 2000 and January 2010. The fall in interest rates as described in Stage 1 is evident as is the rise described in Stage 4.

(Source: www.tradingeconomics.com FEDERAL RESERVE)

In my blog I am going to explore the rise and fall of Lehman Brothers. I believe the rise and fall of Lehman mirrors the rise and fall of the global economy and illustrates the five stages of a financial crisis. I will research Lehman Brothers and aim to define:

·       How Lehman Brothers moves through the stages of the crisis

·       The reasons behind the failure of Lehman Brothers

·       How this failure is connected to the economy

·       The impact of Lehman’s failure on the economy

If you are interested in learning more about the causes of the most recent financial crisis (2007-2009) the video below provides a short summary of what went wrong.

Bibliography

1.      Kindleberger, C.P. Manias, Panics and Crashes: A History of Financial Crises, rev. ed. Basic Books, New York, 1989.

2.      Portes, R. and Swoboda, A. (1987) "Anatomy of Financial Crises." From Threats to International Financial Stability, pp. 10-58. New York: Cambridge University Press, 1987.

3.      Trading Economics. (2013). United States Interest Rates. Available: http://www.tradingeconomics.com/united-states/interest-rate. Last accessed 4th Feb 2013.