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What is a financial crisis?

The term ‘financial crisis’ is broadly used to describe a variety of situations associated with either consecutive large bank failures or  sudden depreciation in the value of financial assets like stocks, currencies, commodities, loans and other financial securities. A financial crisis usually occurs when several institutions simultaneously start showing signs of weaknesses and the appointed market regulator finds it difficult to bail the markets out of the situation. The situation is characterized by loss in confidence of the investors in the value of financial assets resulting in panic sales which further aggravates the situation. Financial crisis is considered precarious because most of them have been prelude to and followed by wide spread economic recessions.

The last 50 years or so have witnessed many major financial crises that have taken the globe by surprise. Charles Kindlerberger in his book ‘Maniacs, Panics and Crashes’, 2000 has pointed that the gone by century was a witness to more than 50 such crisis. (Economic disasters of the twentieth century, By Michael J. Oliver, Derek Howard Aldcroft, 2000, Page 178, 179) The last 9 years have seen more than 5 major financial crises in different parts of the world.

Despite the fact that after every crisis, stricter norms are put in place to strengthen the financial market design, financial crises continue to occur around the globe.

Financial crisis is usually followed by resignation of several top financial market regulators and leaders taking responsibility for the damage. The damage that it brings along include - wide spread losses to investors, cut in jobs, reduction in overall demand, tighter credit norms by banks, curtailment in expansionary planned expenditure, loss in purchasing power, sovereign defaults and a large number of suicide by the broke investors and the persons who have lost their regular sources of income because of the job cuts.

The damage in most of the occasions is simply beyond restore.

Impacts of financial crisis – contents

The impact of financial crisis is widespread and is mostly beyond the evident set of outcomes. The crisis which begins with the financial industry slowly creeps into all other related industries like real estate, mining, manufacturing, tourism, social, food, aviation, international trade (exports- imports), service industry and others. Thus it is extremely hard to fully quantify the impacts of a financial crisis. In many cases, the impacts may be seen after the lapse of long periods of time. Thus giving an exhaustive description of the impact is beyond the scope of this essay.

However to be as inclusive as possible, the essay has been broken down into two aspects:

  1. Sector wise impact of the financial crisis – This section attempts to understand the impact of the crisis on selected sectors of the Economy.
  2. Impact of financial crisis on developed country, developing countries and underdeveloped countries.
  3. Impact analysis – Sector wise

Any financial crisis eventually starts spilling over into other sectors of the economy.  Listed below are the visible impacts of a financial crisis situation discussed industry/sector wise.Financial Sector – The place where a financial crisis begins is the financial Industry.  Banks, stock exchanges, commodity exchange, foreign exchange and other financial markets are the first trigger places for any financial crisis. These are the sectors which being the cause have to bear the brunt directly. The effect on some of the major players in the Financial sectors is briefly spelled out below –

Banks – Many of the world’s greatest financial crisis (including the current US and European meltdowns) begin with banks. Speculative lending at sub prime and weak financial regulatory systems are the two most important causes of the downfall of banks. The worst thing that happens is that despite a plethora of financial analyst analyzing every thing under the sky, fail to caution the investors and several banks start failing one after another catching the investor totally unaware. This situation is followed by run on several banks as the depositors start loosing their confidence on the banking system in general. This panic situation makes thing almost impossible to control for the regulators.  Many experts thus summarize the definition of financial crisis as a situation where “ the banks of a country loose access to the central bank of the country as a lender of the last resort” (Dow’s report on bank crisis, 2000, Page 394)

Currency market players– This is the second most important place from where a financial crisis begins and the impact seen in this sector is one of the most discernible of all. When there is a sudden splurge or fall in the demand of one currency, speculators who loose confidence in the sovereign security of one country try to replace their exposure with a more stable currency. This is what is typically referred to as a ‘speculative attack’. This leads to a wide variation in demand and supply of currencies leading to spread of panic amongst all market players. The panic immediately affects the export and import segments of the entire economy. Many Latin American countries who were faced with this situation defaulted on their debt in the early 1980s.

So how does one know, if a currency market is pointing to a financial crisis. You can know if a currency market is headed towards a financial crisis if there is “A nominal depreciation of the currency by at least 25% and a 10% increase in the rate of depreciation” ("Estimating the Effects of Currency Unions on Trade and Output, Frankel and Rose, 1996, page no. 3)

Stock Exchanges investors – With the fall of a bank or the currency market, stock markets respond almost immediately with a sudden drop in the value of stocks across all the sectors. This happens on the pretext that if the value of an underlying instrument (currency in this case) it self is doubtful, any trade is doubtful. The prices of stock crash leading to major losses for the investors.

Insurance Industry – This industry is perhaps one of the worst hit in case of any financial crisis. With fall in value of an underlying commodity in case of a financial crisis, there are more and more instances of defaults of all types. This results in a sharp increase in forged claims for all such commodities which stand insured. This is especially true for all foreign trades which are badly affected by a sudden change in the geopolitical scenario and bilateral trade terms between countries. These changes firstly affect the exporters and importers. These traders then pass on all the losses to Insurance companies by lodging claims. A sudden rise in claims takes the insurance companies by its surprise.  Settling many claims leave the insurance company battered and broke. Impact on the real estate/ Construction sector

The first indirect impact of any financial crises is witnessed in the real estate or the construction sector. Most of the pre financial crisis period witnesses   high level of monetary growth due to the cheap credit policies of the banks during that period. This results in higher consumption and income followed by an increase of demand of real estate. With the rise in prices of real estate due to increase in their demand, more and more speculators start entering the construction sector to take advantage of the boom. The real estate prices slowly become unduly inflated and turns into bubbles.

This bubble breaks immediately on the advent of any financial crisis. This impact is witnessed in both the public construction and the private construction sector. The public construction work is drastically cut down leading to loss of jobs and incomes. Public construction is one of the major contributors to jobs and incomes in any country. A reduction in public construction work severely hampers the income of several individuals. The problem is even more complicated for the private construction sector. If the real estate is bought out against mortgage from banks, its make matters worse for the banks. With a sudden fall in the value of the real estate, the borrowers also start loosing interest in servicing the loans as the underlying assets (house in this case) starts loosing its worth. This compounds the problem of default for the lending banks, thus adding to the woes of financial crisis. This is precisely what was witnessed in the sub prime mortgage backed lending debacle of the recent US financial crisis. (Bad money: reckless finance, failed politics, and the global crisis By Kevin Phillips, pp 349)

3. Impact on the manufacturing sector.

The manufacturing segment constitutes of sectors like textiles, agriculture, household items, and consumer durables, building materials, automobiles, utilities and all the typical brick and mortar industries.

Any financial crisis leads to a direct reduction in the consumers’ purchasing power followed by fall in demand for manufactured goods. The reduction in manufacturing adversely affects the export demand as well.  Even those manufacturing entities which have no dearth of demand during the period suffer from bank’s unwillingness to offer easier credits during these periods. This aggravates production situation in a wide range of manufacturing sector units.

A decline in the manufacturing sector also results in job losses and a reduction in new job creations. Thus the income generation is further reduced leading setting up a vicious cycle of non productivity.

Most of the industries in the manufacturing sector are hit hard by high interest rates, reduction in domestic consumption, and cancelled export orders.

4.  Impact of financial crisis on the service Industries

We have already discussed the impact of financial crisis on the financial industry in point 1 above. This section thus aims to discuss the effects of financial crisis on other service sectors.

The other prominent service industry includes software, hospitality, communication, transportation, security, management, infotainment, technical consultancy, aviation and others. And as with the manufacturing sector, any industry depends on demand for the products or services. A financial crisis as has been mentioned earlier leads to a direct reduction in the real income of people. This directly reduces the propensity to consume and the associated demand. The financial crisis has thus been found to have adversely impacted all these above mentioned service sector industry very badly.

Software companies are the first to get on a lay off prowl. Most of the companies using software services cut on their discretionary IT spends and more and more firms start to negotiate lower rates with suppliers and cutting back on vendors. This forces the software companies to lower their staff strength on account of squeezed budgets.

Tourism is the second most worst affected sector in situations of financial crisis. Hotel occupancies drop significantly followed by loss in business for travel and tour operators. The aviation sector which is directly dependent on the business and tourism sector crumbles down brazenly. In a recent survey conducted in Several countries of Europe, more than 41% of the respondent stated that they cancelled their holiday trips in 2008, because of the poor financial condition.(A Critical Analysis of the 2007 - 2009 Global Financial and Economic Crisis By Manuel Kaar? - Page 31-33)

Aviation Industry This industry derives all its demand from trade and tourism industry. No surprises then that the industry sees the toughest times with a dip in overall trade and tourism industry. The budget airline companies are the worst affected as they are the ones trying to cash on high volumes. The dip in volumes makes it almost impossible to be running flights for them without incurring huge losses which slowly become unsustainable in the long run.

Given the income/expenditure relationship between the service sector and other industries, a decline in service sector revenue adversely affects the overall purchasing power and further development and expansion prospects. Overall the entire service industry suffers from the deficiency of credit, traumatized consumer confidence and the need to cut on costs.

Impact on developed countries, developing countries and under developed countries

Financial crisis means different things to different people. All the developed, developing and underdeveloped countries are affected, but not always in the same way. While it could mean curtailment in some luxuries of people in developed country, it could well spell out the difference between life and death for people in underdeveloped countries.

We list down the different aspects of the impact of financial crisis on countries at different stages of development.

Impact of financial crisis on developed Countries

For a developed country, the financial crisis would mean a reduction in spending on luxuries, entertainment, travel and similar other factors. This would also mean more bailout packages for institutions in distress. While most of the developed countries can afford a bailout package, the problem does not end there. In fact some analysts feel that the problem actually begins there. Developed countries reeling under the pressures of a financial crisis have to bear brunt.

The first negative impact of a financial crisis in a developed economy stems from the fact that banks in general are not able to lend for the development works to the same extent as they used to do earlier. Most of the development that the world has seen is a result of directed credits to particular sectors where the development was desired.  With banks pulling out their hands from many of these sectors, the development comes to a grinding halt. Projects have to be abandoned midway for want of funds.

This overhang of debt is not only witnessed in the development sectors but also in loans granted for consumption. Banks in these developed countries have found themselves caught up in a situation of excessive financing (Outstanding debt in the US during the recent financial crisis was estimated to be more than 3.5 times the GDP). These excessive private credit in the form of personal loans for consumptions leads to creation of bubbles in the asset prices which eventually meltdown leaving banks, people and economies in distressed conditions.

With a reduction in the production and consumption patterns in the developed economies, large scale job cuts follow. While the developing or underdeveloped countries still somehow manage to swallow this bitter pill, it becomes increasing difficult for people used to improved living conditions and easy ways of life to come to terms with reduction in their spending habits.

Another immediate impact of financial crisis is the busting of asset price bubbles. The more developed and liberalized an economy is, the more complex are its financial instruments and markets. With more speculators playing in these so called developed financial markets, the chances of a higher mismatch and disparities in prices of assets is more. This makes these developed economies more vulnerable to the occurrence of financial crisis and there subsequent aftermaths. Thus these economies witness widespread defaults and shakeouts after any financial crisis.

The financial crisis in developed countries is generally followed by large bailout and fiscal stimulus packages. Bailout packages are generally accompanied with “the imposition of strong conditionality, involving occasionally excessively tight monetary and fiscal policy, which acts as deterrent for repeat offender countries”. (International financial markets: the challenge of globalization, By Leonardo Auernheimer, page 159)

However several scholars have also criticized bail out packages as a relief measure. While these packages might save the day for the country in the short run but these packages eventually leave it under huge public debt burden. Most of these bail-out packages have a limited effect on reducing the panic of investors. The markets are hounded by phases of growing uncertainties and chance of more bad news pouring in from unexpected quarters make it hard for investors to give much importance to any Government incentives which are seen as mere reactions of the Government to save its face in the crisis.

Impact of financial crisis on Developing countries

Developing countries are typically characterized by steadily growing gov­ernment reserves, significant GDP growth rates backed by improvement in export performance and strong current account position.

The extent of impact of a financial crisis (which has happened outside the country’s domain) depends on the extent to which the economy has liberalized its trade policies. A more open economy is bound to have a greater impact of a global financial crisis than in economies which are more self-reliant and less open to International trade. However, a significant characteristic of most of today’s developing countries is that they are fairly liberalized economies. The liberalization results in an increase in financial vulnerability of these developing countries, making them prone to any global financial and currency crisis. A relatively closed economy is better able to withstand the international macro economic challenges created by the downturn in developed economies

The first most visible impact of any global financial crisis on a developing economy is a slump in the export of goods and services. For most developing countries, the developed economies remain the main sources of export demand, and when the developed economies find themselves reeling under financial crisis, exports to these countries declines. This results in loss of production, loss of jobs followed by a loss in purchasing power, demand and consumption. Reduction in exports also adversely affects the Balance of payment position for the developing country. A country which has undergone significant amount of liberalization is heavily dependent on export earnings. Any reduction in export earnings immediately translates into a downgrading of the forecasted earnings of the developing country.

With the consequences of a financial crisis looming large, investors specially the foreign direct investors (FDIs) and foreign institutional investors (FIIs) become more cautious of investing in developing economies. They tend to reduce their exposures to developing countries by pulling out their investments. This limits investment in these countries. With FIIs and FDIs pulling out their investments from the economy, the capital projects are left lurking for investments. The postponement or cancellation of large investment projects because of want of funds in the event of FDIs drawing out results in a negative multiplier effect, as cancelled orders and job losses results in further reduction of demand and consumption.
Another noteworthy impact of financial crisis on developing countries is the significant decline in remittances from the expatriate. Remittances form a major part of foreign exchange earnings for most of the developing economies. There will be fewer economic migrants moving to developed countries faced with financial crisis. This will result in fewer remittances and lower amount of repatriation per migrant. The remittances are the major contributing factors for bulging foreign exchange reserves of many of the developing countries of the world. This reduction in remittances from abroad directly impacts the balance of payment position of the developing economies. (Laborde, D. and Torero, M. Implications of Financial Crisis for Developing Countries, IFPRI, Washington, USA, 2009. Page.38).


Global financial crisis has been found to be a trigger to inflationary trends in many of the developing economies. The inflation is a direct result of increase in prices of food grain, oil prices and other necessities. The central banks of these economies find it extremely difficult to counter the inflationary trends as they are not even in a position to lower the interest rates. Any lowering of interest rate could trigger more borrowing form the banking system. Excessive borrowing is already a cause of concern for the government as banks find themselves caught on the wrong side of the fence by having lent more than desired which triggers a financial crisis situation. Thus inflation is left unchecked in many occasions causing several other economic, political and social imbalances in these developing economies.

Reduction in income from outsourced jobs is a direct fall out of a global financial crisis for the developing countries. Income from outsourced jobs from developed countries forms a major portion of income for developing countries. With developed countries struggling under the influence of financial crisis and with huge job cuts in these economies, the outsourcing attitudes of developed countries hardens and outsourced job opportunities become scarcer. Thus outsourcing is reduced to a large extent. This further dries out income and job opportunities for citizens of developing countries.

Banks in developing countries follow suit of their counterparts in developed countries. They become extremely cautious of lending for either consumption or development. This sets in a fresh cycle of non productivity in an already burdened economy.

Impact of financial crisis on Underdeveloped countries

Survival still remains the biggest question for the citizens of the underdeveloped countries. These countries (mostly located in the African Continent) can hardly be called liberalized economy as trade with other countries is negligible. The typical features of such economies are high and accumulating fiscal deficit situation, higher proportion of spending on current consumption, high level of reliance on aids and grant for survival and negligible income sources. However the mere fact that they are aloof of other countries in matters of trade does not lessen the impact of financial crisis in any way.

The most significant effect of financial crisis on underdeveloped economies is seen in the rise in food prices. Most of the underdeveloped economies are not self sufficient in terms of their food requirements. Most of the food is purchased from other countries and to make things worse, the money for procuring these food is also received as aid or grants. An acute shortage of food is the most difficult part for a majority of the population of these underdeveloped countries and a financial crisis is the last thing that they can sustain.  Any financial crisis is followed by the advent of inflationary trends which is led by increase in prices of food, oil and other essential commodities. The financial crisis actually makes it more difficult for many governments of poor developing countries to secure adequate commodity supplies to feed the hungry people.

Most of the underdeveloped economies rely primarily on inflow of aids from other developed countries for their sustenance. Financial crisis aggravates the fiscal position of the developed countries.  The developed countries thus reduce their budgeted aid outflow to the underdeveloped economies. This often proves to be devastating for these underdeveloped countries.  In normal situations, most of the aid granted by the developed countries are used by the under developed countries for current consumption and very little of it goes towards developmental activity. With a reduction in aid, developmental activities practically come to a stand still.

Underdeveloped countries which export products with high income elasticity are the worst affected in times of financial crisis. The demand for these products reduces drastically with a small change in the income of the importing country. Thus if the importing country is reeling under pressures of a financial crisis, the export is significantly reduced. A under developed country with a high dependence factor on such affect finds no breathing space in such situations. Examples would include underdeveloped or smaller countries solely reliant on income from tourism or other such highly income elastic product.  (Impact of the Global Financial Crisis on Sub-Saharan Africa, International Monetary Fund, USA, 2009)

While a developed country can afford rolling out bail out packages, an underdeveloped economy is generally characterized by high government deficits. Governments with such weak fiscal position cannot offer any bailout packages for its distressed economy. Offering a bailout package would mean borrowing funds from other countries. Being underdeveloped these countries lack access to cheap and easy credit even for development work As such mobilizing funds for bail out seem to be a remote possibility. Thus the situation is to be left to either correct on itself or leave it helplessly to further aggravate.

Any developmental plan requires a planned and consistent injection of capital. All measures for directed credits to development work in underdeveloped economies come to a grinding halt when faced with a financial crisis situation. Developed countries stop any form of funding even to the smaller extent which was hitherto available to these under developed countries.

Besides the financial angle, the social angle resulting from a financial crisis is all the more visible in underdeveloped countries. Lower growth translates into higher poverty. This leads to weaker health systems, higher illiteracy, more corruption, more crime and several other difficulties. Thus financial crisis can turn out to be the final nail in the coffin for these underdeveloped countries.


One common reason behind all witnessed financial crisis seems to be the inherent greed in men to acquire more than is required. This greed has turned the ‘finance function’ from a tool of acting as an intermediary between savings and investment, and transferring resources from capital-rich to capital poor economies to a tool for speculators to rake in the extra mullah out from the system. This has resulted in creation and proliferation of financial instruments that inflate their value often without any real increase in value of the underlying asset. This is an insidious game that has been played for long enough now and this must stop in our own interest.

Countries which are most safe are the once which have kept the use of these financial instruments under strict control by not allowing any of the financial “innovations” to create a messy situation.

To keep the impact of the financial crisis within control, fiscal and monetary policies of all the governments must be decided through a “process of inter-governmental decision-making using the international platforms for such policy decisions.” (CONCORD’s response to the European Response on the Impact of the Financial Crisis, February 2009, Pg no. 1)

To minimize the adverse impacts of financial crisis, there is a need to first recognise the requirement for greater coherence in policies across sectors and amongst countries taking into consideration many factors like trade, climate, energy and other development objectives pertaining to social justice, equality and human rights. Matters of economic policy orientation, of trade, investments, debt-reduction etc. must be thoroughly reoriented from a consistent and comprehensive all round perspective.

The impact of any financial crisis is too widespread to be possibly ever captured in black and white. We can only diarize those impacts which can be quantified. The associated trauma of job losses, losses in investor confidence, rise in fears and insecurities, loss of faith in any administered political and economic systems, loss of value for hard earned money and loss of peace of mind are beyond the scope of any study to quantify.

We can however do our best if we sincerely try to analyze the causes of the financial crisis and deliberate on the methods for collectively avoiding a repeat in the future. These crises recur despite the fact that regulators employ the best intellectual capital and the best technologies to keep unwanted market manipulators away from the market. 

The challenges also lie in being able to create new job opportunities to counter the adverse impacts of recession. “Extending unemployment benefits is the only kind of stimulus that helps each and every unemployed worker, who in some sense has borne the pain of the recession.” remarked Wendell Primus. Jobs creation sets in the economic cycle back to normalcy.

To do all these, we need a thorough understanding on what makes these financial crises recurrent phenomena across the globe and a collective will to keep our greed under control.

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