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 prevalent 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 theory, the economic analysis of the effects of asymmetric information (adverse selection 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 financial crises throughout the world, including the most recent subprime crisis.
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