With such a regime, the central bank seemingly absorbs exchange risks, which gives private investors an incentive to utilise the interest rate differential with the rest of the world that characterises a situation where domestic inflation expectations are higher than in other countries. Loans were therefore obtained in foreign currency for investment in domestic assets. The maturities of the financing instruments often differed from those of the investments—the funds were borrowed short and invested long. When the exchange rate ceased to be perceived as sustainable and the risk of an adjustment grew, the earlier capital inflows turned into massive outflows. This accentuated the pressure on the exchange rate and created an acute currency crisis. If the capital inflow had been channelled through the banking system, the lack of confidence during the acute phase of the crisis often led to severe repercussions on the financial system. The course of events of this type is essentially dependent on the supply of credit. The problem has lain in widespread lending losses and it seems that the banks have repeatedly made much the same mistakes. This applies to their generosity in financing asset investment by private players as well as to the willingness of international banks to supply foreign currency to domestic counterparties. Situations of this type often involve a high concentration of credits and the credit risk assessments appear to have been rather superficial. What are the reasons for this? One is probably the difficulty, for banks as well as supervisors, in assessing the risks in loan portfolios.
A classic example is the tulipmania in the Netherlands, which ended in 1636 with the collapse of the market for tulip options. From the tulip crisis it is also clear that derivative instruments are not a recent innovation in financial markets. The world also saw numerous financial crises in the nineteenth century. As for the present century, what first comes to mind is the crisis in the wake of the stock-market crash in New York in 1929, with effects that left their mark on the global economy in the 1930s. There are various explanations for the Great Depression but it clearly involved widespread financial turbulence and the failure of many banks. In Sweden, too, there were serious bank crises in the early 1920s and ’30s; on both occasions they were accompanied by a deep economic depression and serious deflation. The drop in output and the price level reached two-digit figures before the problems could be overcome. In recent years the pace of financial market development has been rapid. As a result of innovations in communications and information technology, with the new instruments and methods they provide for risk management, the financial system is now more extensive and globalised than ever before. The system channels savings more effectively to those activities in the global economy that need them most. The rapid pace of financial developments and their internationalisation are a logical consequence of arrangements for the production and international exchange of goods and services in the world economy.