In the U.S. financial crisis of 2007–09, there were no widespread bank runs: in general depositors did not line up at their bank and request their deposits, even for banks that were widely reported to be in poor financial condition. This is likely the case because of the widespread understanding of U.S. federally insured deposit insurance, which protects depositors’ funds up to the current limit of $ and the presence of the discount window, by which banks can increase their cash holdings to meet withdrawal demands without having to sell assets at panic prices.12 However, the financial crisis of 2007–09 manifested another type of run on banks as well as non-banks, a run on the short-term, non-deposit debt issued by the intermediaries. This is a point made clearly by Gary Gorton (2012). These runs weren’t clearly and easily visible to the public, and this fact impeded the quick understanding of the severity and potential consequences of the run that was underway. I’ve outlined two strains of thought that provide models for us to understand the mechanisms that amplify what might initially be small shocks into large and dangerous events for the economy: the procyclical leverage of financial intermediaries and their sensitivity to measures of financial risk, such as volatility, and the potential for private intermediaries to issue moneylike instruments.
The clearest outcome of a financial crisis is a loss of output – in other words, a severe and long-lasting recession. Using the same dataset they used to identify crises, Laeven and Valencia found that in advanced-economy nations, the median cumulative decline in output accompanying a financial crisis was 33 percent of annual gross domestic product, or one-third of an economy’s output for a year. In addition, the median growth in government debt was 21 percent of GDP, and the median fiscal cost of the crisis-related spending was 3.8 percent of GDP. Other studies confirm these grim statistics. Reinhart and Rogoff (2009) point out that recoveries from financial crises are weaker and slower than recoveries from recessions that don’t accompany a financial crisis. Employment growth is slower during recoveries from financial crises, and the associated higher unemployment can have long-lasting effects on a whole generation of young workers who sustain long spells of joblessness. There are many other maladies that come along with financial crises. Ingredients Several economic researchers agree that one crucial ingredient in creating the vulnerabilities that can foster a financial crisis is a buildup of debt.5 In particular, a “credit boom,” that is, a high and fast-growing ratio of credit to GDP, is one of the precursors to a financial crisis. Other, somewhat less reliable precursors include a prior financial liberalization or deregulation, housing price booms, and external imbalances (in practice, large inflows of capital from outside the country).