The world in is still reckoning with the legacy of the global financial crisis, which is hardly surprising given its scale and lasting impact. Ten years on from the Lehman Brothers collapse, one question about the financial system keeps coming up: Are we safer than we were in ? The short answer is yes—but not safe enough. While there has been marked progress, more needs to be done, including keeping pace with potential new risks from a rapidly evolving financial landscape.
First, the progress. Banks have bigger and better capital buffers and more liquidity. Countries have taken steps to address systemic risks posed by institutions seen as too big to fail. A substantial portion of trading in over-the-counter derivatives has shifted to safer central clearing systems.
For its part, the International Monetary Fund IMF has improved its ability to analyze and monitor sources of systemic risk. The IMF has improved its ability to analyze and monitor sources of systemic risk. It has partnered with national authorities to help them identify potential trouble spots, such as excessive consumer or corporate debt; develop tools to curb risks; and strengthen analysis of their financial systems.
In the United States, investor demand for debt issued by highly leveraged companies has led to worryingly loose underwriting standards, increasing the risk of default by weaker borrowers. In emerging markets, public debt is at levels last seen during the s debt crisis. And if recent trends continue, many low-income countries will face unsustainable debt burdens. Nonbank finance, also known as shadow banking because it takes place beyond the perimeter of traditional bank regulation, is another source of risk. Regulators must develop and deploy new tools to address it, particularly in those emerging markets where it has expanded rapidly.
At the same time, new challenges have emerged, including the danger of cyberattacks on banks and stock exchanges. And for all the progress to strengthen the financial sector, the revamped architecture remains untested. If financial conditions were to tighten sharply—for example, via unexpectedly higher interest rates or a sharp drop in asset prices—this could expose areas of vulnerability that have built up during a decade of record-low interest rates.
In the last year, we have already seen some investors pull money out of emerging markets in response to a stronger dollar, rising U. That would broadly match outflows during the financial crisis. Looking at the economic context, there are several sources of risk that could shake investor sentiment.
Global growth, while still strong, is leveling off. Support is waning for the open, rules-based international system that has fueled global prosperity, and trade tensions could escalate. Support is waning for the open, rules-based international system that has fueled global prosperity.
Uncertainty about fiscal policy in Europe is reviving worries about the self-reinforcing nexus of government and bank debt that shook the eurozone in the first years of this decade. Finally, central banks must navigate the end of an unprecedented monetary experiment. In the United States, the Federal Reserve may need to raise interest rates higher than currently anticipated if tax cuts combined with fiscal stimulus fuel faster-than-expected inflation. So how should policymakers respond?
First, they must complete financial regulatory reforms and, just as important, resist pressure to roll them back.
The Global Financial Crisis
Bank capital should be raised even further in places where buffers remain low. More progress is needed on procedures for resolving, or winding down, failing banks, especially those that are active across borders. Regulators should encourage banks with weak business models and high levels of nonperforming loans to clean up their balance sheets. Second, policymakers should rebuild their fiscal and monetary arsenals, which were weakened as they contended with the crisis and its aftermath.
Doing so will require reducing budget deficits and gradually bringing interest rates back to normal levels as economic conditions permit. Governments should also work together to reduce excessive global imbalances in a way that supports sustainable growth. Flexible exchange rates can help absorb shocks. Steps to boost lagging productivity would counter demographic headwinds and raise growth, which in turn would support efforts to bolster fiscal and monetary room for maneuver.
Finally, as we consider the lessons of the crisis and the path forward, we must also recognize and confront more profound, longer-term risks to financial—and social—stability. Climate change is one that threatens all of us, low-income countries in particular. Advanced economies must ensure that prosperity is more widely shared, by dealing with rising inequality and stagnant wage growth. All countries need to educate and train workers for automation and the fast-changing workplace of the future.
Many of the measures that might make the world safer than it was before the last crisis depend on international cooperation—on matters of trade and finance but also on a number of global public-good problems, including the environment and refugees. The stakes are just as high as they were in This article originally appeared in the Winter issue of Foreign Policy magazine.
Christine Lagarde is the managing director and chairwoman of the International Monetary Fund. By Fareed Zakaria. Sign up for free access to 1 article per month and weekly email updates from expert policy analysts. Create a Foreign Policy account to access 1 article per month and free newsletters developed by policy experts. Thank you for being an FP Basic subscriber. To get access to this special FP Premium benefit, upgrade your subscription by clicking the button below.
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The subprime mortgage crisis and the bursting of other real estate bubbles around the world also led to recession in the U. Some economists argue that financial crises are caused by recessions instead of the other way around, and that even where a financial crisis is the initial shock that sets off a recession, other factors may be more important in prolonging the recession.
In particular, Milton Friedman and Anna Schwartz argued that the initial economic decline associated with the crash of and the bank panics of the s would not have turned into a prolonged depression if it had not been reinforced by monetary policy mistakes on the part of the Federal Reserve,  a position supported by Ben Bernanke. It is often observed that successful investment requires each investor in a financial market to guess what other investors will do. George Soros has called this need to guess the intentions of others ' reflexivity '. Furthermore, in many cases investors have incentives to coordinate their choices.
For example, someone who thinks other investors want to buy lots of Japanese yen may expect the yen to rise in value, and therefore has an incentive to buy yen too. Likewise, a depositor in IndyMac Bank who expects other depositors to withdraw their funds may expect the bank to fail, and therefore has an incentive to withdraw too.
Economists call an incentive to mimic the strategies of others strategic complementarity.
It has been argued that if people or firms have a sufficiently strong incentive to do the same thing they expect others to do, then self-fulfilling prophecies may occur. Leverage , which means borrowing to finance investments, is frequently cited as a contributor to financial crises. When a financial institution or an individual only invests its own money, it can, in the very worst case, lose its own money.
But when it borrows in order to invest more, it can potentially earn more from its investment, but it can also lose more than all it has. Therefore, leverage magnifies the potential returns from investment, but also creates a risk of bankruptcy. Since bankruptcy means that a firm fails to honor all its promised payments to other firms, it may spread financial troubles from one firm to another see 'Contagion' below.
The average degree of leverage in the economy often rises prior to a financial crisis. Another factor believed to contribute to financial crises is asset-liability mismatch , a situation in which the risks associated with an institution's debts and assets are not appropriately aligned. For example, commercial banks offer deposit accounts which can be withdrawn at any time and they use the proceeds to make long-term loans to businesses and homeowners.
The mismatch between the banks' short-term liabilities its deposits and its long-term assets its loans is seen as one of the reasons bank runs occur when depositors panic and decide to withdraw their funds more quickly than the bank can get back the proceeds of its loans. In an international context, many emerging market governments are unable to sell bonds denominated in their own currencies, and therefore sell bonds denominated in US dollars instead.
This generates a mismatch between the currency denomination of their liabilities their bonds and their assets their local tax revenues , so that they run a risk of sovereign default due to fluctuations in exchange rates. 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. 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. Unfamiliarity with recent technical and financial innovations may help explain how investors sometimes grossly overestimate asset values.
Also, if the first investors in a new class of assets for example, stock in "dot com" companies profit from rising asset values as other investors learn about the innovation in our example, as others learn about the potential of the Internet , then still more others may follow their example, driving the price even higher as they rush to buy in hopes of similar profits. If such "herd behaviour" causes prices to spiral up far above the true value of the assets, a crash may become inevitable.
If for any reason the price briefly falls, so that investors realize that further gains are not assured, then the spiral may go into reverse, with price decreases causing a rush of sales, reinforcing the decrease in prices. Governments have attempted to eliminate or mitigate financial crises by regulating the financial sector. One major goal of regulation is transparency : making institutions' financial situations publicly known by requiring regular reporting under standardized accounting procedures.
Another goal of regulation is making sure institutions have sufficient assets to meet their contractual obligations, through reserve requirements , capital requirements , and other limits on leverage. Some financial crises have been blamed on insufficient regulation, and have led to changes in regulation in order to avoid a repeat. For example, the former Managing Director of the International Monetary Fund , Dominique Strauss-Kahn , has blamed the financial crisis of on 'regulatory failure to guard against excessive risk-taking in the financial system, especially in the US'.
However, excessive regulation has also been cited as a possible cause of financial crises. In particular, the Basel II Accord has been criticized for requiring banks to increase their capital when risks rise, which might cause them to decrease lending precisely when capital is scarce, potentially aggravating a financial crisis.
An economist explains what happens if there’s another financial crisis
International regulatory convergence has been interpreted in terms of regulatory herding, deepening market herding discussed above and so increasing systemic risk. Fraud has played a role in the collapse of some financial institutions, when companies have attracted depositors with misleading claims about their investment strategies, or have embezzled the resulting income.
Examples include Charles Ponzi 's scam in early 20th century Boston, the collapse of the MMM investment fund in Russia in , the scams that led to the Albanian Lottery Uprising of , and the collapse of Madoff Investment Securities in Many rogue traders that have caused large losses at financial institutions have been accused of acting fraudulently in order to hide their trades. Fraud in mortgage financing has also been cited as one possible cause of the subprime mortgage crisis ; government officials stated on 23 September that the FBI was looking into possible fraud by mortgage financing companies Fannie Mae and Freddie Mac , Lehman Brothers , and insurer American International Group.
Contagion refers to the idea that financial crises may spread from one institution to another, as when a bank run spreads from a few banks to many others, or from one country to another, as when currency crises, sovereign defaults, or stock market crashes spread across countries. When the failure of one particular financial institution threatens the stability of many other institutions, this is called systemic risk. One widely cited example of contagion was the spread of the Thai crisis in to other countries like South Korea. However, economists often debate whether observing crises in many countries around the same time is truly caused by contagion from one market to another, or whether it is instead caused by similar underlying problems that would have affected each country individually even in the absence of international linkages.
Some financial crises have little effect outside of the financial sector, like the Wall Street crash of , but other crises are believed to have played a role in decreasing growth in the rest of the economy. There are many theories why a financial crisis could have a recessionary effect on the rest of the economy. These theoretical ideas include the ' financial accelerator ', ' flight to quality ' and ' flight to liquidity ', and the Kiyotaki-Moore model. Some 'third generation' models of currency crises explore how currency crises and banking crises together can cause recessions.
Developing an economic crisis theory became the central recurring concept throughout Karl Marx 's mature work. The theory is a corollary of the Tendency towards the Centralization of Profits. In a capitalist system, successfully-operating businesses return less money to their workers in the form of wages than the value of the goods produced by those workers i.
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This profit first goes towards covering the initial investment in the business. In the long-run, however, when one considers the combined economic activity of all successfully-operating business, it is clear that less money in the form of wages is being returned to the mass of the population the workers than is available to them to buy all of these goods being produced. Furthermore, the expansion of businesses in the process of competing for markets leads to an abundance of goods and a general fall in their prices, further exacerbating the tendency for the rate of profit to fall.
Given the extraordinary capital expenditure required to enter modern economic sectors like airline transport, the military industry, or chemical production, these sectors are extremely difficult for new businesses to enter and are being concentrated in fewer and fewer hands. Empirical and econometric research continues especially in the world systems theory and in the debate about Nikolai Kondratiev and the so-called years Kondratiev waves.
Major figures of world systems theory, like Andre Gunder Frank and Immanuel Wallerstein , consistently warned about the crash that the world economy is now facing. Hyman Minsky has proposed a post-Keynesian explanation that is most applicable to a closed economy. He theorized that financial fragility is a typical feature of any capitalist economy.
High fragility leads to a higher risk of a financial crisis. To facilitate his analysis, Minsky defines three approaches to financing firms may choose, according to their tolerance of risk. They are hedge finance, speculative finance, and Ponzi finance. Ponzi finance leads to the most fragility. Financial fragility levels move together with the business cycle. After a recession , firms have lost much financing and choose only hedge, the safest.
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As the economy grows and expected profits rise, firms tend to believe that they can allow themselves to take on speculative financing. In this case, they know that profits will not cover all the interest all the time. Firms, however, believe that profits will rise and the loans will eventually be repaid without much trouble.
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