Financial crises - 6 recent crises and their lessons learned
Financial crises - these words can cause anxiety and conjure up images of panicked stockbrokers or bankrupt companies. While some historical storms, such as the Tulip Mania of the 17th century or the Great Depression of the 1930s, are lessons in their own right, it is the financial crises of recent decades - since the 1990s - that have most directly shaped today's global economic environment, regulations and our behaviour as investors. As Mark Twain aptly put it: "History does not repeat itself, but it often rhymes."
Financial crises are undoubtedly frightening and can cause great damage. But they are also invaluable teachers. Getting to grips with them, analysing their causes and consequences, will help us to better understand the dynamics of markets, the role of human psychology in the economy and to avoid (or at least mitigate) similar mistakes in the future. In this article, we take a look at major financial crises since the 1990s, examine their anatomy and, most importantly, distil the costly lessons and changes that will help us all navigate the financial world more wisely and consciously.
What is a financial crisis? Short explanation
Before we dive into history, let's briefly define what financial crises are. In the most general terms, financial crises are situations where:
- Financial instruments and assets (such as stocks, bonds, real estate) lose value sharply and extensively.
- Financial institutions (banks, insurance companies, investment funds) run into serious difficulties that could lead to their insolvency.
- The functioning of credit markets is severely disrupted - lending is reduced or stopped because confidence is lost and risks appear too high.
Financial crises often have certain typical elements: speculative bubbles (unjustified and rapid increase in asset prices), panic selling, liquidity crisis (lack of money in the market), businesses and individuals bankruptcies and wider recession.
Recent financial crises and their anatomy (since 1990s)
Since the 1990s, the world has experienced a series of remarkable financial upheavals, each with its own specificities and lessons.
1. The Asian financial crisis (1997-1998): the stumbling block for the "Tigers"
What happened
After years of rapid economic growth, several Southeast and East Asian "tigers" (Thailand, Indonesia, South Korea, Malaysia and others) were hit by a sudden and deep financial crisis. It started with the devaluation of the Thai baht in July 1997 and spread rapidly through the region.
Reasons
The rapid economic growth was partly financed by a large external debt, often short-term and in foreign currency. Many countries had fixed or semi-fixed exchange rates vis-à-vis the dollar, making them vulnerable to speculative attacks. Weak financial supervision, poor risk management in banks and 'crony capitalism' (opaque links between business and political elites) also played a role.
Crash and consequences
Currencies fell, stock markets plunged, many companies and banks went bankrupt. Severe recessions, rising unemployment and social unrest followed. International Monetary Fund (IMF) intervened with large rescue packages, but these were accompanied by severe and often unpopular austerity measures.
Lessons from
- The dangers of fixed exchange rates: in the context of open capital markets, it is difficult to defend fixed exchange rates against speculative attacks.
- Short-term external debt risks: a high reliance on short-term foreign currency denominated debt can be fatal if investor confidence is lost.
- The importance of financial regulation and transparency: strong supervision, adequate capital requirements and good risk management in banks are critical.
- Crisis contagiousness: financial crises can spread quickly from one country to another, especially in regions with similar vulnerabilities.
Changes
Many Asian countries strengthened their financial supervision, moved towards more flexible exchange rates, increased foreign exchange reserves and improved risk management. There was also a growing recognition of the need for regional cooperation to ensure financial stability.
2. The Russian financial crisis (1998): the crash and its aftermath
What happened
In August 1998, Russia was hit by a severe financial crisis, culminating in the devaluation of the rouble and the country's inability to meet its short-term domestic debt obligations (the so-called GKOs).
Reasons
Low oil prices (Russia's main export), chronically high public deficits covered by short-term and very high interest GKO issuance, weak tax collection and the negative impact of the Asian financial crisis on investor confidence in emerging markets.
Crash and consequences
The ruble fell dramatically in value, the government declared a moratorium on some foreign debt and restructured domestic bonds. Many banks went bankrupt and the population's savings lost value. This was followed by a sharp recession and a fall in living standards. The crisis also had a significant impact on neighbouring countries, including Estonia, for which Russia was an important export market.
Lessons from
- Vulnerability of raw material strains: a high dependence on exports of one or more raw materials makes the economy highly sensitive to fluctuations in world market prices.
- The critical importance of the sustainability of public finances: uncontrolled borrowing and a lack of fiscal discipline can lead to sovereign default.
- The role of trust in financial markets: iA loss of investor confidence could trigger a rapid capital outflow and deepen the crisis.
- A direct lesson for Estonia on the risks of its neighbouring markets and the need to diversify export markets.
Changes
In Russia, the crisis later led to tighter fiscal policy, tax reforms and the creation of a stabilisation fund (later the National Welfare Fund) to build up reserves against oil price fluctuations. For Estonia, this provided the impetus to look more actively to Western European markets.
3. The dot-com bubble (late 1990s - 2001): the euphoria and crash of the new economy.
What happened
In the second half of the 1990s, there was a huge optimism and investment boom due to the emergence of the internet and new technology companies (so-called "dot-com" companies). The share prices of many of these companies soared into the stratosphere, often without a clear business model or profitability.
Reasons
Euphoria around the potential of new technology (internet), exaggerated growth expectations, overabundance of venture capital, "profit doesn't matter, it's all about market share" mentality, media hype.
Crash and consequences
From March 2000, the bubble started to burst. Technology stock indices (especially the NASDAQ in the US) fell sharply. Many overvalued and loss-making internet companies went bankrupt or lost value. Investors lost large sums of money.
Lessons from
- The importance of fundamental analysis: don't forget traditional valuation methods (profits, cash flows, business model), even if it is a "new and revolutionary" technology.
- The risk of scuffles: investing should not be about running with fashion. Investing in "hot" sectors should be particularly cautious.
- The dangers of the "this time it's different" mindset: each boom there is a tendency to think that the old rules no longer apply. History shows that this is rarely true.
Changes
While this crisis did not bring about regulatory changes as extensive as the 2008 crisis, it did lead to a certain sobering up of investor behaviour and risk assessment. It is important to note that, partly as a result of the major accounting scandals of the time (e.g. Enron, WorldCom) led to the adoption of the Sarbanes-Oxley Act (SOX), which significantly tightened requirements for companies' financial reporting and internal controls.
4. The global financial crisis (2007-2009): from sub-prime lending to systemic crisis
What happened
This is probably the most widespread and influential financial crisis since the Great Depression, starting in the US housing market and rapidly growing into a global financial and economic crisis.
Reasons
The US housing bubble (sub-prime mortgages), complex financial instruments (CDOs, MBSs), failing credit rating agencies, excessive leverage, too big to fail banks, and global macroeconomic imbalances.
Crash and consequences
The bankruptcy of Lehman Brothers in September 2008 triggered a global panic. Credit markets froze, stock markets fell sharply. Many countries had to bail out their banks with massive rescue packages. A global recession (the Great Recession), rising unemployment and, in some European countries, a sovereign debt crisis followed (see next section). Estonia was hit particularly hard by this crisis, leading to one of the deepest recessions in the EU.
Lessons from
The threat of systemic risk, the downsides of financial innovation, the critical importance of regulation and supervision, the problem of moral hazard, the interconnectedness of the global financial system.
Changes
Dodd-Frank Act in the US, Basel III banking standards (higher capital requirements), strengthening financial supervision in Europe (e.g. European Systemic Risk Board (ESRB), creation of European Banking Authority (EBA)), strengthening consumer protection in the financial sector.
5. The euro area debt crisis (circa 2010-2012 onwards): the aftermath of the global financial crisis in Europe.
What happened
Some euro-area countries (notably Greece, Ireland, Portugal, and later Spain and Cyprus) faced serious difficulties in servicing their public debt. Investors lost faith in their solvency.
Reasons
Long-term high public debt and budget deficits in some countries, exacerbated by the global financial crisis (bailing out banks, recession reduced tax revenues), structural problems (e.g. loss of competitiveness), weaknesses in the design of the monetary union (lack of common fiscal policies and crisis resolution mechanisms).
Events and consequences
Sovereign bond yields rose sharply, threatening them with default. The European Financial Stability Facility (EFSF) was set up and later a more permanent one. European Stability Mechanism (ESM) to provide rescue packages. The European Central Bank (ECB) intervened heavily to calm markets (e.g. with bond-buying programmes). Painful austerity measures and reforms in the beneficiary countries followed.
Lessons from
The challenges of a monetary union without a strong fiscal and political union, the need for public finance discipline and structural reforms, the close interdependence between banks and countries ("doom loop" - country problems affect banks and vice versa).
Changes
Creation of the ESM, steps towards a banking union (common banking supervision, common resolution mechanism), tightening of budgetary rules in the EU (e.g. "Six-Pack", "Two-Pack" legislation).
6. COVID-19 pandemic market shock (2020): global standstill and (so far) rapid recovery.
What happened
The COVID-19 pandemic in early 2020 caused an unprecedented shock to the global economy and financial markets.
Reasons
Long-term high public debt and budget deficits in some countries, exacerbated by the global financial crisis (bailing out banks, recession reduced tax revenues), structural problems (e.g. loss of competitiveness), weaknesses in the design of the monetary union (lack of common fiscal policies and crisis resolution mechanisms).
Events and consequences
Stock markets fell exceptionally fast in February-March 2020 (in some places the fastest fall in history). However, it was also followed by an exceptionally rapid recovery, facilitated by massive stimulus programmes (interest rate cuts, asset purchase programmes, direct subsidies to companies and households) by central banks (including the ECB and the US Federal Reserve) and governments.
Lessons from
- The potential for global shocks (such as pandemics): such events can hit financial markets and the real economy suddenly and hard.
- The role of central banks and governments: a swift and decisive intervention can help to alleviate the depth of the crisis and speed up the recovery, although it may also have long-term consequences (e.g. inflationary pressures, increased public debt).
- Vulnerability and resilience varies between sectors: some sectors (e.g. tourism, entertainment) were hit hard, while others (e.g. technology, e-commerce) proved more resilient or even grew.
- The importance of resilience in business models and supply chains.
Changes
Increased focus on risk tolerance in business models, diversification and shortening of supply chains (reshoring/nearshoring), accelerated uptake of digital solutions and teleworking.
Common denominators and recurring patterns in financial crises (with a focus on more recent times)
While all financial crises are unique, certain patterns recur:
- Human psychology: Greed, fear, euphoria and panic are still powerful forces. The dot-com bubble, for example, was clearly the result of euphoria, while in the 2008 and 2020 crises we saw rapid fear and panic spread.
- Speculative bubbles: Whether it's Asian tiger stocks, internet companies or US real estate, bubbles pop up again and again.
- Excessive amplification: At the heart of the 2008 crisis was a massive leveraging of the financial system.
- Lack of regulation or adaptation difficulties: Financial innovation is often one step ahead of regulation, as complex derivatives showed before 2008.
- Crisis contagion and globalisation: In today's interconnected world, financial crises are spreading fast. The Asian crisis affected Russia, the US crisis of 2008 affected the whole world. COVID-19 was by definition global.
What have we learned? Practical lessons for today's investor
The financial crises of recent decades offer particularly valuable lessons:
- History repeats itself (or at least rhymes): Be aware of patterns. Don't expect "this time it will be different".
- Diversification is your best friend: A globally diversified portfolio is better protected against crises. The Asian crisis showed the realisation of regional risks, while the GFC showed the realisation of global risks.
- Understand what you are investing in: Sophisticated financial products (like CDOs in 2008) can hide unexpected risks. If you don't understand something, you'd better beware.
- Risk of leverage: A particularly important lesson from 2008.
- A long-term perspective: While the downturns can be steep (as in March 2020), long-term investing has historically paid off. The important thing is not to panic sell.
- The role of central banks and governments: Their intervention can have a significant impact on the market (both positive and negative in the long term). Be aware of their policies.
- The importance of liquidity: During a crisis, liquidity may disappear from the market. Keep some of your assets easily liquidated (a 'mental fund').
- The Estonian context: We are a small and open economy, so we are strongly affected by global crises. At the same time, we are also part of the EU and euro area protection systems (e.g. ESM, Banking Union, Guarantee Fund).
To sum up
Financial crises have been, and are likely to continue to be, part of the market economy. The events of recent decades have shown how quickly they can emerge and spread in a globalised world. We have also seen how technology can create both new opportunities and new risks.
But that does not mean we should live in constant fear. On the contrary, learning from the past, especially more recent history, and understanding its patterns and mechanisms, is our best defence and guide to mitigate future risks. A conscious, informed and critically-minded investor will always be better protected than one who acts on emotion or blindly follows others. In today's world, where change is rapid and new risks (e.g. cyber, climate change) may emerge, continuous learning and adaptability are particularly important.
English (UK) 
Eesti