How To Start A Financial Crisis

Guest post by Market Authority 

Today is the start of a multi-part series on the financial crisis: what was the cause and what have we learned. 

When I lived overseas, I was the proud owner of a 1982 Toyota FJ40. Designed as an offroad vehicle, this 4-cylinder diesel could climb just about anything. I’m no gearhead, so once the truck started experiencing problems, fixing it was quite the learning experience. Some issues were easy to fix, such as replacing cheap glow plugs with a higher quality set or a worn down hose with a newer one. While I’m still not an expert on diesel engines, I’m now more familiar with how they operate and can diagnose simple problems when they arrive. The universal truth is that nobody really wonders how the engine works until it fails to start in the morning. 

And the same principle applies to financial markets. Only when a crisis happens, do we pop open the hood and take a look at the problems with the system. We discover issues that a previous mechanic may have installed incorrectly or parts that need to be entirely replaced due to overuse. Some of these may be quick fixes while others may require a complete rebuild. 

Every financial crisis starts with a complete loss of confidence in what’s under the hood. When fear is prevalent, investors sell assets  and raise cash. Because of this action, the economy loses the financing necessary to grow and output falls. 

The financial crisis of 2008 allowed us to diagnose the problems in our financial system and propose solutions to avoid similar events in the future. This is how economic systems evolve, through a crisis/recovery process leading to a better understanding of how the entire system operates. 

For instance, before the Federal Reserve was created in 1914, bank runs were a national pastime. At every peak in the business cycle, depositors would worry that their local bank had underwritten too many bad loans. Fearing their cash was no longer safe, they would line up outside the local bank demanding their money back. This was a powerful signal. If you were walking through town and witnessed your neighbors waiting anxiously (and sometimes angrily) in line, you were likely to inquire what all the fuss was about. When you were told your money was at risk, you would likely join the line, reinforcing the signal. The risk of losing all of your deposit was much greater than the reward earned from keeping it in the bank.