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Causes of financial crises

Learning Object Description:
It is difficult to identify the main cause or causes for financial crises. While some blame
actors such as investors, banks, or speculators, others blame structures such as insufficient
regulations, an absence of institutions, and a missing lender of last resort. This section
evaluates arguments for and against both positions. We argue that financial crises have
complex causes, which are often oversimplified in public debate.
Learning Object Objectives:
To acknowledge the fact that there are many possible causes of financial crises; to propose
arguments why actors (investors, banks, speculators) or structures (insufficient regulations, a
lack of institutions, a lack of a lender of last resort) can be made responsible for financial
crises; and to be aware of the fact that establishing causal relations between factors is
difficult due to the complexity of financial crises.

Financial crises are complex. Whether problems in the financial sector develop into a crisis or not
depends on many factors, including the fragility of previous credits, the speed with which expectations
are reversed, the extent to which confidence declines as a result of a financial accident, the regulation
of the banking industry, and the degree to which the financial community has confidence in the central
bank's role as a lender of last resort.
Thus, the main cause (or causes) for financial crises is not easy to identify. In the public arena, as in
academia, opposing explanations are hotly debated. As this lesson shows, these explanations can be
discussed as two different approaches to the issue.

Who is responsible, the driver or the road?

Using the analogy of a car accident, we might ask who is responsible, the driver or the road?

Did the driver behave carelessly or irresponsibly? Or was the road in a bad condition
(and perhaps invited careless behavior)?

In the debate about the causes of financial crises, some observers blame the actors, while others blame
the structures.

Actors: Blaming the driver

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Those who focus on the actors blame economic actors (investors, banks, speculators, etc.) for financial
crises. They criticize the mania and panic of investors, saying investors' decisions are led first by greed
and later by fear. These critics highlight investors' shortcomings in predicting crises. In literature on
economics, Charles Kindleberger has analyzed the effects of expectations on financial markets. He
shows that financial instruments involve commitments across time and thus are affected by
perceptions of the future. For example, equity and bond markets trade securities involving future
dividend or coupon payments by corporations or governments. Expectations are important. Economic
literature recognizes explicitly the role of irrational expectations and group psychology in critical
stages of a financial crisis. People are often motivated by fear, rumour, and panic psychology in
critical situations, and accordingly behave differently from rational expectations that economists
usually postulate.
Alan Greenspan, chairman of the Federal Reserve, warned in 1996 that unrealistic expectations of
economic actors would result in "irrational exuberances of the [US stock] markets". His voice was not
heard. In the following years, investment in US technology shares rose, causing what we today call the
IT bubble.
Others blame economic actors for intentionally provoking financial crises. These observers tend to
speak of "speculators" rather than of "economic actors". The term "speculators" often implies that
economic actors cause financial crises for their own profit. While in some cases speculating attacks
against a currency have caused the currency's devaluation (e.g. the British pound in 1992), this
approach can never explain the whole story. The Institute of International Finance has found that
private investors lost some US$225 billion during the Asian financial crisis and some US$100 billion
as a result of the 1998 Russian debt default. Nevertheless, the notion of the malicious speculator
remains popular. At the G-7 meeting in Halifax 1995 (after the Mexican financial crisis) then-French
president Jacques Chirac called the international speculators the HIV virus of the global economy (see
Bayne, Nicholas 2000: Hanging in There. The G7 and G8 Summit in Maturity and Renewal, Ashgate:
Aldershot).
Question:
What do people say who blame economic actors for causing financial crises?
Option : Investors are motivated first by greed and then by fear
Option : Economic actors cause crises by failing to respond in time to problematic developments
Option : Some economic actors try to provoke financial crises intentionally
Option : Most economic actors are not adequately trained

Structures: Blaming the road

Those who focus on structures blame insufficient regulations, the lack of institutions, or the lack of a
lender of last resort. In a stricter sense, these critics also blame specific actors, namely national
government, for not having provided this structure. However, the main point of such an argument is
the view that there are deficits in the structure of financial systems. The call for a new financial
architecture typically comes from those who hope that if structures were improved, financial crises
could be avoided. In the aftermath of the Asian crises, Canadian Minister of Finance Paul Martin said:
"It is not reasonable to expect sovereign governments to follow rules and practices that are 'forced' on
them by a process in which they did not participate. Therefore, whatever form the renewed global
financial architecture ultimately takes, all countries must 'buy into it' and take ownership." (Quoted in:
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Porter, Tony 2000: The G-7, the Financial Stability Forum, the G-20, and the Politics of International
Financial Regulation, www.g7.utoronto.ca/g20/g20porter/index.html [08/07/2005]).
This view expressed what many policy makers felt at the time. It is a mixture of the argument that
blames economic actors and the argument that blames faulty or lacking institutional structures, which
are seen as unable to cope with market developments. The finance minister of the G-7 asked former
president of the German Central Bank (Deutsche Bundesbank) Hans Tietmeyer to scrutinize the
financial architecture. Tietmeyer's report concluded: "National and international regulatory authorities
must also develop procedures to ensure that market participants pay heed to the standards that have
been developed in managing and pricing the risks they incur with respect to their counterparties."
Tietmeyer's report later became the founding document of the Financial Stability Forum, established in
1999.
Question:
What do people say who see the causes of financial crises in inadequate economic structures?
Option : To avoid financial crises, we need a new international financial architecture
Option : The International Monetary Fund is to blame for financial crises
Option : National and international regulatory authorities must regulate financial markets more
effectively
Option : To prevent a global financial crisis, all countries must develop rules and regulations in a
concerted effort

This cartoon (source: www.derivativesstrategy.com) illustrates the debate over

possible causes of financial crises. It accuses the government, and not economic
actors, of causing crises.

Hyperlink to:
http://www.derivativesstrategy.com/magazine/comix/9602_1.asp
Derivatives Strategies
Read the entire comic on Derivatives Strategies.

Discussion
The debate about whether or not the road or the driver is to blame is far from decided. Both sides have
made important arguments and have thus contributed to the reform of the financial architecture.
Nevertheless, the complexity of the debate poses a problem when the topic is discussed in public and
not by experts. Policy makers often paint a picture of mysterious financial markets. The following
statement made by Gerhard Schrder just before he was elected German chancellor is one of many
examples:
"When Alan Greenspan recently admitted that he himself did not completely understand the workings
of the international financial system, I was reminded of Goethe's magician's apprentice: Could it be
that politics has reached the point where it can no longer subdue the speculative spirits that it helped to
create through deregulation?" Gerhard Schrder at Georgetown University (05/08/1998)

Conclusion: Blaming the driver or the road?

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Question:
How would you personally summarize the discussion concerning the driver and the road?

The question of who is responsible for a financial crisis cannot be answered by either explanation (the
driver or the road) alone. The danger of oversimplifying the debate is twofold. First, such
oversimplification might give the impression that policy makers have no influence over what happens
on financial markets and so are not responsible for the financial distress and social consequences
caused by crises. Second, it might give the impression that global financial markets are a danger to,
rather than the source of, the economic wealth of a country. But if this were true, we would have to
ask why the policy makers of all advanced industrial countries continue the policy of global financial
integration.
External Document:
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External Document:
Risk Download a printable document with a definition of risk.
External Document:
References Download and print out a list of recommended literature.

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