Month: December 2019

This blog post will help you find out what the worst financial crises in history are, what started them, and how they affected the world. Most of us are aware of the financial crisis of 2008 and the global economic recession (large-scale job cuts, a decline in the wealth and assets of people) that followed. Even though a decade has already passed, the world has still not recovered from it.

A financial crisis can cripple a country by destroying it from the inside. Let’s look at the four most devastating financial crisis that destroyed people’s lives and reduced their lif-time savings to ash.

Financial crises in history

A financial crisis is a situation in which the values of assets fall steeply. As the costs of assets decline, fearing further depreciation of these assets, most investors (both people and companies) who invested in these assets try to sell them at the same time, leading to a reduction in demand for these assets.

Due to the decline in demand, the values of these assets fall further. The investors, who end up selling them, now have a shortage of assets. Due to the loss incurred by selling the assets at lower prices, they have less money to pay their debts.

When this transforms into a large scale problem, the government intervenes to rescue the financial institutions.

1. The Great Recession of 2007-2008

On 15th September 2008, Lehman Brothers, one of the oldest, largest investment banks in the world, filed for bankruptcy. This is considered to be the official start of the financial crisis of 2007-2008.

How did it happen? – The sequence of events

1. At the beginning of the 21st century, real estate booms in the US. Investors borrow credit from banks to invest in real estate. Banks provide cheap loans in the hopes that they will get them back.

2. However, from 2005, due to the rising global energy prices, the (negative) gap between people’s incomes and their debts widens.

3. Therefore, people are not able to repay their mortgages to the banks.

4. This leads to a decline in demand for real estate properties. Due to the fall in demand, the values of real estate properties (including those that were mortgaged by people) and other assets held by banks and other financial institutions fall as well.

5. Many influential banks in the USA and the UK come to the brink of collapse.

6. The government pumps in billions of dollars to rescue these financial institutions from collapsing.

7. Meanwhile, in Europe, the sovereign debt crisis takes shape.

The European sovereign debt crisis – The sequence of events

8. Due to the financial crisis of 2007-2008 and the economic recession that follows, the banking system of Iceland completely breaks down.

9. In 2009, this spreads to Spain, Portugal, Greece, Italy, and Ireland.

10. The other European countries, fearing the collapse of the European Union, agree to bailout (providing vast amounts of money) the affected countries. In exchange, they demand austerity measures like temporarily increasing the tax rate and reducing public spending.

11. The collapse of the financial system of these countries reduces the FDI (Foreign Direct Investment) in these countries, whereas the adopted austerity measures lead to public turmoil.

Some of these countries (for example, Greece) still haven’t recovered from this crisis.

2. The 1998 Asian financial crisis

In July 1997, a financial crisis began in East and Southeast Asia, which almost caused a worldwide economic meltdown. The crisis began with the collapse of the Thailand currency (Baht).

How did it happen? – The sequence of events

1. From 1985 to 1996, Thailand has the highest economic growth rate (9% p.a.) in the world. Its currency, Baht, is pegged (fixed at a specific rate so that it cannot vary) to the US Dollar. This high economic growth rate is mostly due to its exports, and also due to the high interest-rate offered by Thailand’s banks attracting foreign investors to deposit more dollars in Thailand’s banks.

2. Being optimistic, Thailand borrows heavily to invest in real estate and other projects.

3. At the same time (beginning of the 1990s), the US is slowly recovering from a recession. To counter the high inflation rates in the country, US banks increase the interest rates. Simultaneously, the cost of the US dollar rises in the global market.

4. Both these developments in the US affect Thailand adversely. Since the cost of the US dollar has increased in the global market, the prices of Thai products increase as well (since Baht is pegged to the US dollar). Now, Japanese and German products become cheaper to their Thai counterparts.

5. As a result, exports in Thailand decline sharply. Simultaneously, foreign investors choose to invest in US banks instead of Thailand’s banks due to the increased interest rates in the US.

6. Left with no other choice, Thailand unpegs the Baht to opt for a floating exchange rate (the value of the currency is no more fixed to the US dollar, it can change) and devalues the Baht (For example, if one dollar was 50 Bahts before, now it will be 70 Bahts).

7. The intended results are simple: Exports in Thailand will increase. However, imports will become extremely costly. Hence, people will buy domestic products instead of foreign products.

8. However, due to the steep increase in exports, all wealth flows out of the country. As a result, capital flight (disappearance of wealth) ensues, reducing the purchasing power of Thailand tremendously. This makes several services dependent on imports very costly (for example, some medical surgeries become too expensive because the devices needed become too costly to import).

9. At the same time, the Thailand government is unable to repay all the foreign debt, because, now, Thailand has to pay more Bahts for the same amount of dollars.

10. Thus, the Asian financial crisis begins. Within a few years, it spreads to the neighboring Southeast Asian and other Asian countries and eventually to Russia and Brazil.

11. The IMF (International Monetary Fund) steps in to rescue the sinking economies. It pumps in billions of dollars. In exchange, the borrowing nations are forced to implement austerity measures.

12. By the end of 1999, the economies of several affected countries have stabilized.

3. The OPEC Oil Embargo of 1973

Organization of Petroleum Exporting Countries or OPEC, in short, is a group of 14 countries that are the world’s major oil exporters. The oil crisis began in October 1973, when members of the OPEC issued an oil embargo against the US and other allies of Israel.

Food for thought:

What is an embargo?

An embargo is a penalty (commercial or financial) issued by a country against another country or an individual. An embargo can also prohibit partial/complete trade with that country or group of countries.

How did it happen? – The sequence of events

1. Till 1971, the US followed the Gold standard, and other countries traded in US dollars. However, in 1971, President (of the US) Nixon takes the US off the Gold standard. Hence, countries that hold reserves of American dollars cannot exchange it for gold anymore.

2. Since the value of the American dollar is not tied to any fixed asset anymore, the value of the American dollar depreciates.

3. Oil is sold in US dollars. Hence, with the decline in the value of the American dollar, the revenue of OPEC falls as well.

4. At the same time, the US supports Israel in the war against Egypt.

5. Both these factors aggravate the OPEC and push it to stop oil exports to the US and other allies of Israel.

6. In a single year, oil prices quadruple.

7. Now, people have to spend more money on oil. As a result, they have less money to spend on other goods. At the same time, the prices of common goods increase, leading to inflation, unemployment, and, ultimately, recession.

8. The oil embargo finally comes to an end in March 1974.

4. The Great Depression (1929 – 1939)

The Great Depression is the worst financial crisis of all time. It began on 29th October 1929 with the stock market crash, costing the jobs of 15 million Americans (25% unemployment rate) and reducing the GDP of the world by 15% (During the Wall Street crash of 2007 – 2008, the GDP fell only by 1%).

How did it happen? – The sequence of events

1. During the 1920s, the economy of the US develops at a fast rate. The wealth of the US doubles during this period, and this period would later come to be known as the ‘Roaring Twenties.’

2. Even though the prices of most items remain stable, the stock prices soar to the sky, increasing four-fold during this period.

3. This increase in stock prices encourages people, ranging from prince to pauper, to invest in stocks. Those who don’t have enough money, lend money from banks to invest in stocks.

4. Since the rise in stock prices is irrational, it instills fear in people’s minds. They start believing that if irrational growth is possible, an irrational decline is also likely.

5. Since the rise in prices is irrational, the government tries to regulate it by increasing the interests of banks. The government hopes it will encourage people to borrow less and invest less in stocks.

6. However, this severely affects investments in sectors like construction and automobile, for which people heavily depend on loans from banks. This reduces production (since people buy less, companies start producing less), and people have less work (not necessarily fewer jobs).

7. At the same time, the prices of stocks fall slightly. Since people had less confidence in stocks, many of them sell their stocks at this point. As a result, the prices of stocks fall further (due to lower demand), and people start selling more, triggering a chain reaction.

8. Since many people have already lost a lot of money in stocks, they reduce their spending in other areas, probably to preserve wealth for an uncertain future.

9. Consequently, the production in the US (because demand has reduced) and its wealth start declining steeply by the end of 1929. This ultimately leads to the loss of jobs.

10. During the Autumn of 1930, people, fearing that banks might close down, demand that their money-deposits be paid in cash. Since most banks only hold a portion of their assets as liquid cash, this leads to banking panics throughout the US. A banking panic arises when a lot of people demand that their deposits in banks be paid in cash, at the same time. As a result, banks try to liquidate most of their loans hastily. This causes several banks to fail.

11. This continues until 1933. By that time, 20% of the banks that existed in 1931 have already failed.

12. Due to the Gold standard, the economic downfall of the US also perpetuates to the countries in Europe. The Gold standard is an agreement that many countries signed to make international trade easier. The participating countries fixed the values of their currencies with respect to the cost of gold. As a result, the values of these currencies were fixed against each other.

Food for thought:

What are the advantages of Gold standard?

In the Gold standard, the value of a country’s currency is dependent on the amount of gold it owns. Anyone who has that currency can submit it to the government to get gold equivalent to that value. Since the country can only print as much money as the amount of gold it possesses, it helps prevent inflation and stabilize the economy.

13. The banking catastrophe ends only in 1933 when President Roosevelt issues a four-day banking holiday. During this time, Congress passes reform legislation. After the holiday, only the banks that are found not to fail are reopened.

14. He also sets up several organizations to protect the citizens’ deposits in banks and to regulate the stock market.

15. At the same time, nations around the world (including the US) abandon the gold standard and devalue their currency. This gives them more freedom because they can fix the value of their currencies without worrying about the exchange rates (and gold standard).

16. As a result, the economies of several nations start recovering slowly. In the US, the economy recovers steadily between 1933 and 1937, and the money supply grows by 42% in this period.

Recession within the depression – The Recession of 1937 – 1938

17. Even though the economy has started to grow, the government still has huge budget deficits. So, the government starts reducing government spending and increasing taxes.

18. At the same time, fearing that an increase in the money supply will cause inflation, the US government implements two new policies.

Food for thought:

How can an increase in the money supply lead to inflation in the country? 

Increased money supply means more money in people’s wallets. More money in people’s wallets means they are willing to pay more to purchase goods. Thus, the prices of consumer goods increase due to an increase in demand, leading to inflation.

19. The government doubles the reserve requirement ratios (Amount of liquid cash / Total amount of customers’ deposits) for banks and sterilizes all the gold in the system by storing them away in federal reserves and not allowing them to enter into circulation.

20. These two improvements strongly limit the expansion of money. Very soon, the supply of money starts to decline; people have less money to purchase; production declines; and unemployment increases, leading to another recession in 1937- 1938.

Recovery

21. To push the country out of recession, President Roosevelt rolls out a major spending program to increase people’s purchasing power and requests that the Federal Reserve Board reduces its reserve requirements.

22. As a result, the country starts to come out of recession slowly. However, the economy is still not back to pre-depression levels.

23. At the same time, the US increases its military spending, due to the fears of the Second world war. This, in turn, increases the government’s budget deficits. To save the economy, the Federal Reserve uses its reserve cash and gold to increase the money supply. This boosts the economy by providing more jobs.

24. Finally, the second world war brings the Great Depression to an end. Second world war is not the direct reason for the end of the Great Depression. However, the jobs (military, navy, air force, arms production, etc.) it created and the push it gave to the Federal Reserve, to push its cash and gold reserves into the monetary system, ends the Great Depression.

We hope that you liked this blog post about the worst financial crises in history. If you liked this blog post, also check out the following blog posts:

1. How to save your money?

2. Basics of investing

3. What are cryptocurrencies?