Centre for Economic Policy Research

Abstract

A financial crisis is a disturbance to financial markets, associated typically with falling asset prices and insolvency among debtors and intermediaries, which spreads through the financial system, disrupting the market's capacity to allocate capital. In this paper we analyze the generation and propagation of financial crises in an international setting. We provide a perspective on the danger of a serious disruption to the global financial system by comparing the last full—fledged financial crisis — that o the 1930s — with conditions prevailing today. Our definition of a financial crisis implies a distinction between generalized financial crises on the one hand and isolated bank failures, debt defaults and foreign—exchange market disturbances on the other. We represent this distinction in three sets of linkages: between debt defaults; and between exchange—market disturbances and bank failures. In both the 1930s and 1980s, the institutional environment was drastically altered by rapid change in foreign exchange markets, in international capital markets, and in the structure of domestic banking systems. Our comparative analysis underscores the critical role played by institutional arrangements in financial markets as a determinant of the system's vulnerability to destabilizing shocks.