Anatomy of a Financial Crisis
A financial crisis is a sharp disruption in which asymmetric information problems explode, so funds stop flowing to productive uses. A typical sequence runs from a credit boom with rising leverage and an asset-price bubble, to a bust in which falling asset prices erode bank balance sheets and uncertainty climbs, to bank panics and deleveraging, sometimes ending in a debt-deflation spiral.
Why it matters
When asset prices fall and uncertainty spikes, lenders can no longer tell good borrowers from bad, so they retreat from everyone. Credit dries up for healthy and unhealthy borrowers alike, which deepens the downturn.
Worked examples
Order these stages of the 2007 to 2009 crisis: bank panic, the housing bubble bursts, a credit boom in mortgages.
The credit boom in mortgages came first, then the housing bubble burst, then the bank and shadow-bank panic of 2008. Each stage worsened the asymmetric-information problem and choked off lending.
Common mistakes
- ✗Crises are just bad luck or random panics. They follow a recognisable pattern driven by leverage, asset prices, and asymmetric information.
- ✗A crisis is over once the panic stops. Deleveraging and tight credit can depress activity long after the acute panic passes.
Revision bullets
- •A crisis is an explosion of asymmetric-information problems
- •Sequence: a leveraged credit boom and bubble, then a bust that erodes bank balance sheets, then bank panic
- •Deleveraging and tight credit prolong the damage
Quick check
During a financial crisis, lending often collapses for healthy and unhealthy borrowers alike because
Connected topics
Sources
- Mishkin (2018), Ch. 12Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.Financial crises in advanced economies: the stages of a crisis, the role of asymmetric information, and the 2007-2009 crisis.