What are the economic consequences of a financial crisis? (2024)

Key takeaways from this article

• Enhanced policy responses:

  Strengthening economic policies can mitigate a financial crisis's impact. By enhancing safety nets and providing stimulus, you help to sustain spending and protect the most vulnerable.

• Building resilience:

  Focus on developing robust institutional frameworks. This proactive approach fosters stability, ensuring your financial system can better withstand future shocks.

This summary is powered by AI and these experts

• Riccardo Domini Senior Financial Crime AML/CTF Analyst…
• Branko Neskovic Diplomat and publicist

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  A financial crisis has profound economic consequences, notably leading to reduced output and income. As financial intermediaries struggle to provide credit and liquidity, households, businesses, and governments face a credit squeeze, resulting in diminished investment, consumption, and public spending. The inevitable outcome includes surging unemployment, increased poverty rates, and growing income inequality. The extent and duration of these output and income losses are contingent on the crisis's severity, scope, and the efficacy of policy responses and institutional safeguards.

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• Branko Neskovic Diplomat and publicist

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  The consequences are, first of all, loss of trust and insecurity, and if the crisis continues, then a lack of ideas and apathy will follow, which can cause long-term consequences for society.

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  A financial crisis results from a Central Bank mismanaging its monetary policy. There are two ways it does this.1. It distorts interest rates unnecessarily because it misunderstands the effect that a change in interest rates has on buying habits. There is a simple inverse relationship between interest rates and asset prices. Reduce Bank Rate and the result is asset bubbles that eventually burst. Raise interest rates and asset prices fall disrupting asset markets E.g the housing market.2. Quantitative easing or quantitative tightening cause the quantity of money to grow excessively causing inflation or contract causing deflation. Either damages market signals and distorts product markets.Solution: don’t do either of the above.

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• Mustafa O. Pasha, CFA Economy | Capital markets | Investing

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  The consequences may vary depending on the underlying reasons/economic structure but generally financial crises in emerging markets are characterised by:Unsustainable fiscal/external deficitsSignificant currency depreciationRapid increase in price levelsThe impact of these can be a long term loss of:industrial outputdecline in purchasing powerincreased povertyGovts are often forced to seek bailouts which entail imposing austerity measures to stabilize the economy. While the economic impact can be measured in lower GDP growth, inflation, unemployment and can exhibit rapid recovery, the human impact of job losses, decline in living standards and higher mortality rates can take years to recover from or in some cases be permanent.

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  While financial crises can be challenging and even devastating for many individuals and businesses, opportunities can be found during these times. Seize opportunities during a financial crisis:1. Invest in undervalued assets: This presents an opportunity for investors to buy these assets at a discount and hold onto them for the long term.2. Start a new business: There may be less competition and lower costs associated with starting a new business.3. Reevaluate your career path: Industries less affected by the crisis may offer more job opportunities.4. Focus on cost-cutting and efficiency: Reducing unnecessary spending.A financial crisis can present opportunities for selective thinkers.

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• Shakeel Jeeroburkan ACSI Snr Fund Accountant at Fidelity International - Master of Business in Investment Fund Administration Candidate - 2023 Apprentice of the Year Award Winner (Finance Category)

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  Financial crises don't just impact pocketbooks, they also take a toll on mental wellbeing. The increased uncertainty and volatility during such times often lead to heightened stress and anxiety levels, which can manifest in a range of mental health issues, from depression to substance abuse. These issues aren't just personal tragedies, they also have wider economic implications. Poor mental health can lead to reduced productivity, increased healthcare costs, and, in severe cases, a loss of human capital. Thus, the mental health impacts of a financial crisis can serve to extend and deepen its economic fallout.

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  The death spiral is usually the scariest part of a financial crisis. Hence it becomes imperative for the authorities to intervene promptly and effectively to nip the issue rightvat the bud.

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  1. GDP Decline: The gross domestic product typically declines by up to 50% more during a recession that follows a financial crisis. 2. Unemployment: Job opportunities decrease, leading to a rise in unemployment.

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  Financial crises amplify uncertainty and volatility, shaping the cautious, pessimistic, and defensive behavior of households, firms, and governments. Higher risks and reduced confidence lead households to save more and spend less, firms to cut costs and postpone investments, and governments to adopt austerity measures. This collective response creates a vicious cycle, reducing both demand and supply in the economy. The resulting contraction and instability contribute to prolonged economic challenges. Recognizing and addressing the psychological impact on economic agents are essential for fostering resilience and a more robust recovery from financial crises.

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• Luis Canas Economist | Master in Innovation | Business Intelligence | Artificial Intelligence | Marketing | Finance

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  Because of the increased uncertainty and volatility in Financial Crisis, interest rates tend to go higher to every level: governments, households, firms; world banks, public banks and other finacial institutions start to increase risk factors in their business to be prepared in case of a growth of default situation from many borrowers

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• Jason Schenker Futurist | Economist | 1,000x Keynote Speaker | 36x Author | 15x Bestseller | 26x #1 Bloomberg Forecaster | 1.2 Million Online Learners | Board Member | CSIS Adjunct Fellow | Forbes Contributor

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  Financial markets and the economy are driven by two factors - Fear and Greed. In a financial crisis, fear reigns supreme.When fear is driving the economy, it reinforces negative economic dynamics. And it is difficult for the economy to break out of a downward cycle.This is where supportive monetary policy (like Fed rate cuts) and supportive fiscal policy (like government spending) are critical for turning the tide in the economy, incentivizing the financial system (and the players in it) to allocate resources and facilitate investments.With supportive policies and time, the greed dynamics in the economy will begin to dominate. Then investors and businesses will take on more risks, leading to economic activity, expansion, and growth.

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• Shakeel Jeeroburkan ACSI Snr Fund Accountant at Fidelity International - Master of Business in Investment Fund Administration Candidate - 2023 Apprentice of the Year Award Winner (Finance Category)

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  Another dimension of impaired financial stability is the effect on financial innovation. During a crisis, the focus often shifts from developing new financial products or technologies to risk mitigation and compliance. This can stifle the financial sector's ability to innovate, potentially slowing down advancements that could benefit consumers and businesses alike. For example, initiatives like mobile banking expansion or peer-to-peer lending platforms may be put on hold. The reluctance to innovate can prolong the recovery period and may result in missed opportunities for financial institutions to adapt and evolve.

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• Tomislav Lissa Vodanovic ✔ Administración | Magíster en Educación Superior |

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  El deterioro de la estabilidad y la eficiencia financiera, es a mi juicio la consecuencia económica más importante de una crisis financiera. En respuesta a la erosión financiera, y a la preponderancia de la tecnología en todos los ámbitos de la vida, surgió por ejemplo en el año 2009 el Bitcoin y con mayor fuerza la aparición de las FINTECH, en mercados emergentes y desarrollados.

  Translated

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  In the realm of Economics, the aftermath of a financial crisis is profound. My expertise underscores the implications, notably impaired financial stability and efficiency. Such crises inflict solvency, liquidity, and valuation issues on intermediaries, markets, and instruments, eroding trust and confidence. Bank runs, asset fire sales, and contagion effects ensue, disrupting resource allocation and transaction facilitation. The post-crisis recovery and reform demand considerable time and resources, posing enduring challenges. As an enthusiast economist, I navigate these complexities, recognizing the far-reaching economic consequences and advocating for strategic interventions to mitigate their impact.

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• Tendani Mantshimuli, Cert. Dir Certified Director | Economist | CFO | COO driving profitable growth

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  I agree, as confidence in the financial system is impaired there will be a contagion effect to other asset classes. Also, the risk rating for banks and even the country will be negatively impacted. This makes it expensive for government to service its debt and redistribute spending away from providing essential services. This is especially problematic in developing countries

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• Arun Singhal

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  The policy actions taken after the 2008 financial crisis and its consequences are a good example. Policies of financial repression, low or even negative interest rates have resulted in increasing inequality. Further, they have sown the seed of next crisis by encouraging an increase in leverage both in the private sector as well as the public sector. The balance sheets of governments and central banks are in a precarious position today. Inflation has eroded purchasing power of the savers and pensioners. Given the high levels of debt and current interest rates, chances of a deflationary bust are quite high.

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• Shakeel Jeeroburkan ACSI Snr Fund Accountant at Fidelity International - Master of Business in Investment Fund Administration Candidate - 2023 Apprentice of the Year Award Winner (Finance Category)

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  In relation to altered economic structures, it's noteworthy that crises often encourage a shift towards local economies. As global supply chains get disrupted, both consumers and businesses might look for local alternatives for goods and services. This can lead to a resurgence of local businesses and can also promote sustainable practices, like reduced shipping and production miles. On the downside, this inward focus may limit exposure to global markets, potentially affecting long-term competitiveness and economies of scale.

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  Many analyses of financial crises emphasize the role of investment mistakes caused by lack of knowledge or the imperfections of human reasoning. Behavioural finance studies errors in economic and quantitative reasoning. Psychologist Torbjorn K A Eliazon has also analyzed failures of economic reasoning in his concept of 'œcopathy'.[20]Historians, notably Charles P. Kindleberger, have pointed out that crises often follow soon after major financial or technical innovations that present investors with new types of financial opportunities, which he called "displacements" of investors' expectations.

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• Thomas Praz Multi-Asset Sales Trader at Banque Cantonale de Genève

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  As the credit standards and conditions tighten, corporations normally see their market-based weighted averaged cost of capital (WACC) increase. An increase in WACC can lead to some activities losing their value-add status and actually destroying value for the company, and sometimes even becoming totally unprofitable.To adapt to this increase in WACC, companies are incentivised to reduce their net debt, by not reinvesting cash in new activities, shutting down some production, and repaying debt.Governments may try to limit the width of this effect by increasing public spending.Central banks may try to counteract the effect of tighter credit conditions by lowering their target interest rates.

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  One notable effect is the alteration in the composition and distribution of output, income, and wealth. Certain sectors, regions, and demographic groups may benefit while others face setbacks. Patterns of consumption, saving, investment, and innovation can also change in the wake of a financial crisis. Institutions and policies adapt to mitigate vulnerabilities and enhance stability, leading to legal, regulatory, fiscal, and monetary revisions. In essence, a financial crisis prompts adjustments across the economic landscape, fostering structural changes, modified behaviors, and enhanced policies that influence the future economic trajectory.

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• Shakeel Jeeroburkan ACSI Snr Fund Accountant at Fidelity International - Master of Business in Investment Fund Administration Candidate - 2023 Apprentice of the Year Award Winner (Finance Category)

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  While spillover and contagion effects are often discussed in an international context, less attention is given to localised spillover effects within a country. A financial crisis can exacerbate regional disparities, where affluent areas may recover quicker than economically disadvantaged regions. This uneven recovery can lead to social tensions, as those who are less affected may not fully grasp the prolonged hardship faced by others. This internal rift can be as destabilising as international conflicts, affecting national social cohesion and potentially leading to civil unrest.

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• Ghulam Mohey-ud-din Principal Economic Planner | Parsons Corporation | Ph.D. in Economics

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  Furthermore, the interconnectedness of financial institutions and markets in the era of globalization intensifies the potential for spillover effects. In times of crisis, investor confidence and risk aversion can spread rapidly, leading to contagion as uncertainties and market pressures spill over from one region to another. International policy coordination and collaboration become crucial to mitigate the adverse impacts of financial crises, emphasizing the need for effective regulatory frameworks, early warning systems, and cooperative measures among nations to enhance global financial stability and resilience.

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• Christine Ng'ang'a Advisor

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  For countries that are net importers, they experience imported inflation from higher commodity prices in the international markets which can also lead to currency depreciation/exchange rate volatility. This can create a vicious cycle whereby the country experiences more inflation and a slowing down of economic activity, which in the end results in stagflation.

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• Kent Oliver Bhupathi, MEcon Economist, Data Scientist + Adjunct Prof @ NYU

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  Oh boy 😅 getting this in under 750 characters… A financial crisis significantly disrupts economic stability, primarily through the tightening of credit conditions. Credit crunches, for instance, hamper growth by restricting access to finance for consumers and businesses, leading to reduced investment and spending. Additionally, such crises erode confidence in financial institutions, fostering a risk-averse atmosphere among investors and consumers alike. The effects extend beyond national borders, impacting global trade and investment — and these spillovers more often than not [politically] highlight the need for robust financial regulations to mitigate future risks (the pendulum always swings back around, though).

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• Konstantinos Spanos Lecturer at Oxford Brookes Business School

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  When the economy of a country is weak, one of the most important spillovers is the unemployment, which in turn can trigger social and political unrest. There is not fiscal space for governments to expand public spending to face the stress times of the economy.

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• Viren Kumar KPMG | BITSoM | NISM | Manipal

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  In a credit crunch born from financial crises, innovation, particularly for smaller enterprises, faces formidable challenges. As credit tightens, these ventures, essential for economic dynamism, struggle to secure the capital needed to drive their creative engines. Research and development budgets are slashed, hiring freezes are imposed, and expansion plans are put on hold. The scarcity of credit not only hampers ongoing innovation but also discourages potential entrepreneurs from entering the market. This imbalance concentrates innovation within cash-rich corporations, stifling diversity and hampering economic resilience. Policymakers ultimately have to step in to offer stimulus and additional incentives to foster further progress.

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• Shakeel Jeeroburkan ACSI Snr Fund Accountant at Fidelity International - Master of Business in Investment Fund Administration Candidate - 2023 Apprentice of the Year Award Winner (Finance Category)

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  Another aspect to consider is the potential shift in consumer preferences that can occur following a financial crisis. As household budgets tighten, there's often a move away from luxury or non-essential items towards basic goods and services. This shift can force companies to pivot their product lines and marketing strategies, sometimes leading to long-lasting changes in business models. For example, a focus on value-based goods may emerge, causing a decline in demand for high-end products. This shift isn't just a short-term phenomenon; it can alter the competitive landscape of various industries and lead to significant market realignments.

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• Dr. Jilvan Pinheiro Souza Júnior Venture Capital Fund Manager

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  Consideration of government policies supporting innovation and startups is crucial. During financial crises, initiatives such as tax incentives, funding programs, and regulatory support for innovative startups become increasingly vital. For instance, in Brazil, during economic downturns, targeted government support for research and development, tax breaks for tech startups, and streamlined regulatory procedures can significantly bolster the innovation sector. These policies can encourage entrepreneurial activity and innovation, fostering the resilience of startups even in challenging economic times.

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  A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy.Many economists have offered theories about how financial crises develop and how they could be prevented.

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• Darren Quinn Unconventional economic thinker dedicated to reforming policies to prioritise social justice and empower society’s disadvantaged

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  Economic downturns from financial crises often lead to recessions and heightened unemployment, with banks tightening lending, causing businesses and consumers to pull back on spending and investment. The value of investments, including homes and retirement accounts, can drastically drop, resulting in substantial wealth loss across the board. These crises can also severely affect consumer and business confidence, trigger long-term structural economic changes, and induce inflation or deflation. Modern Monetary Theory (MMT) suggests that governments can intervene by managing buffer stocks of essential commodities or assets to stabilise prices, regulate supply-demand dynamics, and support a robust and sustainable economic recovery.

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