Economic Crisis: Types and Effects

What’s it: An economic crisis refers to a condition in which the economy is shaken unexpectedly and rapidly spreading. The trigger can take various forms, such as a debt crisis, a banking crisis, an asset bubble burst, and a balance of payments crisis.

For example, a debt crisis occurs when the risk of default soars. The government’s ability to repay debts falls. Government debt increases dramatically, higher than the increase in tax revenue. The government cannot borrow any more money because investors have lost faith in the government’s ability to pay.

Some economists argue that most economic recessions or depressions originate from financial crises. One notable example is the Great Depression, which started with a bank run and a stock market crash.

The 2008-2009 subprime mortgage crisis also triggered a severe recession in the United States and spread worldwide. The cause was the bursting of the real estate bubble. Real estate prices have risen so much that they have exceeded fair value. And, suddenly, the price fell. That sparked panic in the economy because of the large sums of money being invested in real estate.

The crisis has an impact on economic activity and raises some socio-political problems. GDP growth slumped, the unemployment rate shot up, and many people lost their money. Poverty and hunger increased, giving rise to problems of crime and riots. In some countries, the crisis led to the removal of the incumbent government.

Types of economic crises

Many economists offer theories about how economic crises arise, develop, and spread in the economy. They also propose several options to prevent worse effects.

However, there is no right consensus or formula. The crisis continues from time to time.

In general, economic crises can take many forms. I will try to discuss five of them, namely:

Currency crisis
Banking crisis
Asset bubbles
Balance of payments crisis
Debt crisis

Currency crisis

The currency crisis is considered part of the financial crisis. Currency crises occur when the exchange rate of one currency against another falls. In other words, it’s currency depreciation, it’s just going badly.

The currency crisis may be the result of hyperinflation—the purchasing power of the domestic currency over goods and services declines. People don’t believe in domestic currency anymore. They sell domestic currency and exchange it for a more stable currency such as the US dollar. As a result, the domestic currency exchange rate against the US dollar falls.

Currency crises may also occur due to speculative activity. Speculators attack weak currencies, especially countries with weak economic fundamentals. Typical targets are countries that:

Adopting a fixed exchange rate system
Running double deficit (fiscal deficit and current account deficit)
Having insufficient foreign exchange reserves

Those countries are vulnerable to small attacks on exchange rate markets. Foreign exchange reserves are insufficient to intervene and reduce the effects of speculators’ attacks. As a result, the exchange rate depreciates.

Depreciation increases debt denominated in foreign currency, say US dollars. Governments and businesses must raise more money to pay back the debt.

Businesses try to avoid increasing debt burdens by buying dollars. That move might save them from default. But, that had other consequences. The purchase of dollars exacerbates the fall in the exchange rate.

Banking crisis

A crisis usually starts with a bank run, when savers suddenly withdraw their deposits from the bank. Such panic maybe because they lost confidence in the purchasing power of the domestic currency as during hyperinflation. Or, they no longer trust the bank because of insolvency problems.

During hyperinflation, the purchasing power of the currency falls. People prefer to hold cash because they can use it at any time. That triggered massive withdrawals of deposits in banks.

Banks have difficulty paying back deposits. They usually only set aside a small portion of the savings as a reserve. The rest, they lend to households or businesses. Banks, of course, cannot suddenly withdraw their loans.

Withdrawal of deposits suddenly makes the bank bankrupt. That sparked panic, not only among savers but other banks as well. The banks are usually linked to each other, for example, through interbank loans. Such a situation then led to a banking panic and a systemic crisis.

Asset bubbles

A crisis usually occurs when an asset bubble bursts suddenly. Assets can take many forms, such as stocks or real estate. The significance of the effect depends on how much money is invested in these assets. The more money invested, the worse the effect.

Asset bubbles occur when the asset price continues to surge rapidly, far exceeding its fundamentals. Prices are no longer reasonable and far exceed their fair values. One of the causes is a speculative activity.

Speculators are trying to take advantage of price increases in the short term. They buy assets only in the hope that they can later sell them back at a higher price. Purchases make prices skyrocket even more.

Having exceeded its fundamentals, it suddenly falls. That sparks panic, not only among speculators but other long-term investors. Households lost some of their wealth, and so did businesses.

Balance of payments crisis

This crisis occurs when a country is unable to pay for imports or service its foreign debt payments. A fall in exchange rates usually accompanies a crisis.

One of the causes of the balance of payments crisis is short-term capital flows (or what we call hot money). Foreign investment flows into the domestic economy to take advantage of fast economic growth. Foreigners hunt for assets such as stocks and bonds.

Others are more long term oriented. They invest directly in building production facilities or acquiring domestic companies.

If economic conditions weaken (e.g., contraction), it pushes short-term foreign investment out of the domestic market. Capital outflows result in sharp currency depreciation.

The government tries to intervene in the exchange rate by using foreign reserves. But, it may not work because of the massive capital outflow.

The government then took other options, for example, by raising interest rates. The expectation of a rate hike prevents further declines in the currency’s value. However, a sharp increase in interest rates only further hurt the domestic economy and reduce investor confidence.

Debt crisis

A debt crisis arises when the risk of default increases. Debt soared because the government ran a budget deficit that was getting higher from year to year. At the same time, the ability to increase tax revenue is limited.

High debt causes the government’s ability to pay interest and principal to fall. Investors’ confidence over the domestic economy slumped.

The European debt crisis since 2010 is an example. Several eurozone member countries, such as Greece and Spain, were unable to pay back their debts. They were then forced to ask for help from third parties, such as the European Central Bank (ECB) and the International Monetary Fund (IMF).

These creditors forced the government to implement austerity policies and fiscal discipline. They must reduce the level of their budget deficit through tax increases and decreases in government spending.

Economic crisis impacts

The economic crisis has had a broad impact on the economy and even the social conditions of society. I’ll break down some of the adverse effects:

Unemployment spiked. Economic crises lead to a recession or even depression, forcing businesses to cut output due to weak demand. They began to rationalize production costs by firing some of their workers.
Household wealth falls. People’s incomes drop because of the higher unemployment rate. Those who are still working may also have to receive lower salaries as the business measures efficiency and rationalizes operating costs. Falling assets worsen the situation and reduce household wealth. They incurred capital losses and no longer received regular payments, such as dividends.
Deteriorated business profits. Demand for goods and services falls as household income and wealth fall. Falling demand left most production facilities unemployed. Businesses cannot operate at economies of scale, increasing the unit cost of the product.
Social crisis. Poverty levels soar as household income and wealth fall. It triggers an increase in social problems such as crime and hunger.

Economic Crisis: Types and Effects