When we talk about financial crises, we have only one certainty on our side: sooner or later, there will be another one. Banks that fail, bubbles that inflate for months and then deflate within a morning, currencies in turmoil and sovereign states or other large issuers that go into default: the trigger points are many and difficult to predict in their entirety, given the 'high number of variables at play.
Looking back, however, a common denominator emerges: the consequences on the real economy in terms of production, employment, income, savings and household consumption.
What are financial crises
Defining what a financial crisis is is not easy because every crisis can take different forms and arise under different conditions. Fortunately, literature has taken care of unraveling the intrigued situation. A recent study by the International Monetary Fund1, identified four families of financial crises based on quantitative and qualitative considerations.
- Currency crises: a speculative attack on the currency causes a devaluation or sharp depreciation or forces the authorities to defend the currency by investing large amounts of international reserves or by drastically increasing interest rates or imposing capital controls.
- "Sudden Stop” (also balance of payments crisis): it can be defined as a large and sudden decrease in foreign capital inflows or more generally an abrupt reversal of capital flows.
- Banking crises: the news, more or less founded, of a bank's difficulty and/or the collapse of its stock on the Stock Exchange can kick off the "race to the counter", with account holders who want to close their accounts en masse. In this way, the bank in question risks becoming insolvent, because it is unable to meet the total amount of liquidity requested by customers at the same time, and is forced to ask for help from the State or limit the availability of movements on current accounts .
- Debt crisis: can lead to a sovereign or private debt crisis. A debt crisis occurs when a person is unable or unwilling to honor his debt, and therefore defaults. There are various ways to not honor the debt: inflation, not paying interest, extending the maturity of the contract, other forms of support.
The frequency of seizures
Relying on our medium-term memory, we remember the crisis very clearly subprime game in 2007 and that of the debt of 2011. Is that enough?
Not really: a work by Laeven and Valencia2 (also the IMF) counted 431 from 1970 to 2011. If during the 2s currency crises averaged 7 per year, in the 9s they became XNUMX per year, up to XNUMX per year (again on average) in the XNUMXs.
Over the past 40 years, currency and banking crises have dominated, but since the 2000s they have greatly reduced in number (not in intensity, however, if we think of the Lehman crisis). To date, however, modern economic systems seem more exposed to Sudden Stop crises.
As you can imagine, very often crises overlap. For example, the recent eurozone crisis has gone through a Sudden Stop, a public debt crisis and a banking crisis. Just so you don't miss anything. The chart below shows the countless intersections between the various crises. Apparently, banking crises have a lot in common with any other crisis. Banks, as we know, matter.
The 5 basic characteristics of a crisis
Financial crises can therefore take very different forms, even if they have several aspects in common:
- Disproportionate increase in asset prices
- Rapid increase in credit volumes
- Severe deterioration of financing conditions (bank channel or external sources)
- Serious budgetary problems for businesses, households, financial operators and sovereign states
- Urgent interventions by the government or supranational bodies
Among these 5 factors, the outrageous increase in asset prices (particularly house prices) and growth in credit volumes are the most common in the run-up to financial crises.
The sharp and rapid increase in asset prices (stocks or otherwise) followed by massive downward corrections is a phenomenon that has been repeated often over the centuries (remember the "tulip bubble"?). As can be seen from the graph below, periods in which credit or property prices have risen sharply have been followed by periods of financial crises or periods of substandard economic growth, or both.
Impact on the economy
Financial crises, wherever they come from, clearly have strong effects on economic activity and can trigger recessions, the International Monetary Fund explains. Now, the economic cycle is in itself "programmed" to cross - cyclically, in fact - four phases: recovery, expansion, slowdown, recession.
Then, to say that the recession stems from the financial crisis is inaccurate. There can be a recession even in the absence of a crisis. It is true, however, as the IMF points out, that financial crises often tend to make recessions worse than the "natural" ones: the average duration of a recession associated with a financial crisis is about six quarters, two more than to a normal recession.
There is usually a larger decline in output as well, and more: post-crisis recessions show much larger declines in consumption, investment, industrial production, employment, exports and imports. Furthermore, the combination of the costs of restructuring the financial system and a struggling economy can cause public debt to rise very rapidly.
The effects on the markets
A financial crisis is generally followed by the depreciation of the currency, the fall in the value of shares and bonds, more difficult access to loans and mortgages and, last but not least, risks for liquidity and capital mobility.
Defend yourself from a financial crisis
If it were possible to predict when and how the next crisis will unleash, we could give a punctual answer in every part on how to defend ourselves. Unfortunately, however, financial crises are very difficult to predict. Of course, hypotheses can be made: the withdrawal of the extraordinary measures of the central banks and the widespread political risk, in addition to the delicate situation of the public finances of some countries (such as Italy) can give us some clues, but they do not give us any certainty precisely because, as mentioned, the variables involved are many. All we can do is get ready and keep our nerve.
As? diversifying, of course. But beware: correlations between many investments are relatively low when all is well, but rise when things go badly, i.e. in financial crises. If under normal conditions when the Stock Exchanges go up the bonds go down (and vice versa), the crisis acts as a "level" and sends everything down.
Well, not quite everything. Gold, short-term government bonds of "safe countries" and liquidity (with particular attention to the solvency of the bank where we have deposited our savings) have little correlation with the other asset classes and it is therefore from here that we can derive some protection in crises.
In short, in managing savings, taking care not to put everything in a single investment (never), don't be afraid to also focus on risk-free activities, therefore with very low returns. Finally, remember to strategically vary the composition of the portfolios.
SOURCE: Advise Only
In the section where one should explain how to defend oneself from the crisis, this is not done and the topic is dealt with briefly and with little depth. With all due respect, I don't find this a helpful article