The recurrence of financial crises can be prevented by taking bold steps
The history of financial crises—which have recently caused significant upheavals in Turkey as well—dates back to periods when the banking system and stock markets had come to play a decisive role in shaping the contemporary economy. Financial crises emerging following such periods are, unfortunately, quite common throughout history and frequently lead to economic tsunamis in the affected economies. One of the first examples to go down in history is the financial crisis of 1637, commonly known as the ‘Tulip Mania’; this was a speculative bubble in the tulip bulb market in the Netherlands, where the bulbs were highly prized for their beauty and rarity.
During the bubble, driven by speculation and investment, the prices of tulip bulbs soared to extraordinary levels. However, the bubble eventually burst, leading to a sharp fall in prices and causing the financial ruin of many investors. This crisis is often cited as an early example of the dangers of irrational exuberance and speculative bubbles in financial markets.
Approximately 100 years after this crisis, the ‘Credit Crisis’ erupted in London in 1772 and rapidly spread to the rest of Europe. By the mid-1760s, the British Empire had amassed immense wealth through its colonial territories and trade. This situation fostered an atmosphere of excessive optimism and led to a period of rapid credit expansion by many British banks. This euphoria came to an abrupt end on 8 June 1772, when Alexander Fordyce, a partner at the British banking house of Neal, James, Fordyce and Down, fled to France to evade his debt repayments.
The news spread rapidly and triggered a banking panic in England; creditors began forming long queues outside British banks to demand immediate cash withdrawals. The resulting crisis quickly spread to Scotland, the Netherlands, other parts of Europe and the British American colonies. According to historians, the economic repercussions of this crisis were one of the key factors contributing to the Boston Tea Party protests and the American Revolution.
Regional conditions and British trade policy gave rise to two distinct trade systems, leading to two different types of credit provision. On the one hand, trade policy necessitated a reciprocal flow of goods between British merchants and plantation owners. Large plantation owners would deliver their produce to British merchants, who sold it on a commission basis; these merchants would then purchase goods and supplies to take back to the plantation owners, and subsequently charge the plantation owners for any shortfalls in their open credit accounts; these credits were generally interest-free for a period of one year.
Under a separate system known as the ‘merchant-factor system’, merchants – mostly based in Glasgow – traded directly in commodities, goods and materials with colonists via agents in the colonies. These agents conducted their business from local shops in the colonies, which served as convenient sales outlets for British goods.
Similarly, agent shops also provided interest-free credit for a period of one year. Evidence suggests that the merchant-factor system was utilised more extensively by medium-sized plantation owners and that, by 1772, this system had grown to such an extent that it overshadowed the original commission system by up to three times; in short, this rapid growth, particularly in lending, paved the way for the outbreak of the crisis.
The world also entered the 20th century in the midst of a crisis; whilst the ‘1901 Crisis’ was a relatively minor one, it was regarded as the ‘first stock market crash’ on the New York Stock Exchange due to the takeover of Northern Pacific Railway shares (that is, the attempt to gain control of a company by purchasing all existing shares).
This first crisis of the new century also served as a precursor to the ‘Bankers’ Panic’ or ‘Knickerbocker Crisis’ that erupted in 1907; this was because another failed speculative corner had been taken (in the United Copper Company), which in turn triggered numerous bank runs. The corner at the Knickerbocker Trust Company, which also manipulated copper prices, created a domino effect, leading to the stock market crash, a liquidity crisis and further bank panics. This crisis also led to the establishment of the Federal Reserve System in 1913; this system was designed to prevent future financial crises by acting as a lender of last resort and implementing monetary policy.
Another major financial crisis that left a deep mark on history is the ‘Great Depression of 1929–1939’, known as ‘the worst financial and economic catastrophe of the 20th century’. Triggered by the Wall Street crash of 1929 and subsequently exacerbated by misguided policy decisions by the US government, the Great Depression lasted for almost 10 years and led to massive losses of income, record-high unemployment rates and a decline in production, particularly in industrialised countries. In the US, the unemployment rate reached nearly 25 per cent at the height of the crisis in 1933.
According to economic historians, the initial decline in US production in the summer of 1929 stemmed from a tight monetary policy—which was, of course, based on high interest rates—aimed at curbing stock market speculation. Prior to this period, the 1920s had been a decade of prosperity; as there had been no extraordinary boom, prices had remained virtually stable throughout the decade. However, share prices had risen more than fourfold from their 1921 low to their 1929 peak. The US Federal Reserve (Fed) raised interest rates in 1928 and 1929 in the hope of slowing the rapid rise in share prices. These high interest rates reduced interest-rate-sensitive spending, such as on construction and car purchases; this, in turn, led to a decline in production.
Subsequently, the Second World War, as we know it, broke out, and afterwards, a global economy emerged that was increasingly focused on space and technological developments within the rising bipolar world; that is, until 1973, when member countries of the Organisation of the Petroleum Exporting Countries (OPEC) declared an oil embargo, abruptly halting oil exports to the US and its allies. This situation led to a severe oil shortage and a sharp rise in oil prices, causing an economic crisis in the US and many other developed countries. The unique aspect of the ensuing crisis was the simultaneous occurrence of very high inflation (triggered by rising energy prices) and economic stagnation (caused by the economic crisis). Consequently, economists dubbed this period ‘stagflation’ (recession plus inflation), and it took several years for production to recover and for inflation to fall back to pre-crisis levels.
Although conditions today are very different, there are lasting lessons to be learnt from this crisis that remain relevant today. One of these is the importance of maintaining a constant focus on energy security, which must also encompass the resilience of the system. A remark made by Winston Churchill during a debate on oil policy in the British Parliament in 1913 remains a fundamental principle for energy security: “Security and certainty in oil,” he said, “lie in diversity, and in diversity alone.” In other words, diversification. When markets are calm, it is all too easy to overlook energy security. The second lesson is the need for transparency and high-quality information regarding supply and demand and what is actually happening in the market. This will not only reduce the panic and confusion that exacerbate the situation but also prevent the search for scapegoats, which distracts from efforts to resolve the problem. Today, US President Donald Trump’s move to provoke a ‘war with Iran’ – aimed at keeping prices high by restricting supply in response to the impact of declining oil demand driven by climate action – stands out as a move that can be assessed on the same basis.
Another major global economic crisis began in Thailand in 1997 and rapidly spread to the rest of East Asia and its trading partners. Speculative capital flows directed towards East Asian economies—such as Thailand, Indonesia, Malaysia, Singapore, Hong Kong and South Korea (known at the time as the ‘Asian Tigers’)—triggered a period of optimism that led to excessive credit expansion and a build-up of debt in these economies. In July 1997, citing insufficient foreign exchange reserves, the Thai government was forced to abandon the fixed exchange rate against the US dollar that it had maintained for many years. This triggered a wave of panic across Asian financial markets and rapidly led to the withdrawal of billions of dollars in foreign investment. As panic spread through the markets and investors began to fear the possible default of East Asian governments, fears of a global financial collapse began to take hold.
It took years for the situation to return to normal. The International Monetary Fund was forced to intervene by putting together bailout packages for the hardest-hit economies to prevent these countries from defaulting.
The events, also known as the ‘Asian Financial Crisis’, generally caught market participants and policymakers off guard. Before the crisis erupted, certain vulnerabilities were well known, particularly in Thailand; however, it was also believed that these countries’ economies had many strengths. As the crisis progressed, it became apparent that the strong growth records of these economies had masked significant vulnerabilities.
In particular, “years of rapid domestic credit growth and inadequate supervision had led to a significant increase in financial leverage and the accumulation of non-performing loans”. Overheating domestic economies and property markets heightened risks and led to increased reliance on external savings; this manifested itself in rising current account deficits and the accumulation of external debt.
Heavy external borrowing, which was predominantly short-term, exposed companies and banks to significant exchange rate and funding risks; these risks had been masked by long-standing fixed exchange rate regimes. When it became apparent that fixed exchange rate regimes were unsustainable, companies saw sharp increases in the value of their external debt denominated in local currency, a situation that left many firms in dire straits and even drove some into bankruptcy.
Another major financial crisis centred on ‘stock markets, markets, funds…’ occurred more recently, during the period 2007–2008. It triggered the Great Recession – the most severe financial crisis since the Great Depression – and caused widespread devastation in financial markets worldwide. The crisis, triggered by the bursting of the US housing bubble, led to the collapse of Lehman Brothers (one of the world’s largest investment banks), brought many major financial institutions and businesses to the brink of bankruptcy, and necessitated government bailouts on an unprecedented scale. It took nearly a decade for the situation to return to normal; during this period, millions of jobs and billions of dollars in revenue were lost.
Once the turmoil in the financial markets had subsided, attention naturally turned to regulatory measures focused on the financial sector, with the aim of preventing similar events from occurring in the future. Under the rules of the Bank for International Settlements (BIS), there have generally been significant increases in the required capital levels for traditional banks; these increases are even more pronounced for ‘systemically important’ institutions.
Regular stress tests will help both banks and regulators to understand the risks and, should conditions deteriorate, will compel banks to use their profits to build up capital rather than pay out dividends.
As we have seen, in response to major financial and market crises that have shaken economies – and consequently thousands of organisations and millions of people – at a global level for around 2.5 centuries, countries have generally intervened along three main axes: monetary policy, fiscal policy and structural reforms. Whilst the emphasis of these interventions may vary depending on the scale of the crisis and the country’s level of development, central banks have taken—and continue to take—swift action during crises to dispel panic in the markets and keep the wheels turning.
In such situations, ‘interest rate cuts’ were the first steps taken in virtually all countries as a key condition for keeping the market alive by reducing borrowing costs. Furthermore, to provide expanded liquidity, long-term funds were made available to banks and non-bank financial institutions; in addition, the necessary arrangements were put in place for the central bank to purchase distressed assets or government bonds.
Furthermore, to offset the economic contraction, governments deployed budgetary measures, making infrastructure investments and employment support packages available to the wider economy; and, not content with this, they utilised tax cuts to the fullest extent possible to boost consumption. To support all this, many countries made significant cuts to public spending whilst increasing social benefits as much as possible. At this stage, direct intervention was carried out to support financial institutions to prevent the collapse of the banking system – a key sector – and, to this end, public capital was injected into banks on the verge of collapse.
To ensure that savings held in banks were backed by state guarantees, ‘deposit guarantees’ were put in place; during such periods, many countries secured conditional emergency credit support from organisations such as the IMF and the World Bank. Alongside the support provided during these processes, the scope of support was broadened as much as possible through low-interest loans.
Governments have also, throughout history, developed strategic intervention tools—which vary depending on the type of crisis, such as ‘liquidity, debt or structural collapse’—whilst resolving major financial and market crises. In this context, central banks typically began with emergency intervention, often described as ‘financial triage’; they then rebuilt the system through structural reforms and international cooperation. Among the principles underpinning these structural reforms is the provision of support funds at the lowest possible interest rates, with the aim of minimising costs and paving the way for the system to function again.
On the other hand, when these major financial crises occurred, legal, regulatory and financial sanctions were imposed on the responsible institutions and executives.
Governments also forced fund managers, stockbrokers and major banks – whom they identified as being among those responsible for the deep crises – to pay fines amounting to billions of dollars. For example, US authorities imposed fines totalling tens of billions of dollars on three major banks and numerous fund management companies for fraudulent activities involving toxic mortgage-backed securities dating back to 2008.
In addition, regulatory bodies banned certain individuals from working in the banking or securities sectors. Furthermore, companies reclaimed the bonuses and other incentive payments they had made to executives deemed responsible for taking ‘irresponsible’ risks.
Many countries have gone even further, implementing comprehensive legislative reforms to prevent further market crashes. For example, in the US in 2010, the Dodd-Frank Act came into force, introducing stricter capital requirements, stress tests and consumer protection rules for banks. In Europe, too, regulations were introduced regarding the Banking Union and stricter supervision by the European Securities and Markets Authority (ESMA). Alongside these, international economic sanctions (such as SWIFT bans and the freezing of central bank assets) were implemented.
Today, in Turkey, where poverty is becoming increasingly severe due to the impact of high interest rates implemented to curb inflation, studies and statements regarding the extent of the damage caused by the ‘funding crisis’ are emerging one after another. Given that the numerous regulatory measures introduced in the wake of similar crises around the world should be taken as a model, it is clear that there are still many steps to be taken; what matters most is to prevent the fruits of labour—saved by thousands of people under difficult conditions—from being wiped out one after another should similar problems arise. The most important prerequisite for this is to take the first step boldly and press ahead.
