Chapter 12
Financial Crises in Advanced Economies
Financial crises are inherently interesting because they are so dramatic. This has become even
more the case with the recent global financial crisis that has had such devastating consequences
for not only the U.S. economy, but for Europe as well. Indeed, teaching this material on the
financial crises has engaged students’ interest more than anything else I have taught in my entire
career of over thirty years of teaching.
After defining the basic asymmetric information concepts, the chapter outlines the dynamics of
financial crises in advanced economics by separating crises into three phases: the initial phase in
which financial innovation or liberalization occurs, but is deeply flawed, so it leads to a credit
boom and bust, the second phase of a banking crisis, and the third phase, which only occurs in
the worst financial crises, of debt-deflation, in which a decline in the price level causes a further
deterioration in household and businesses balance sheets. Figure 1 is particularly useful to get
students to see the sequence of events and dynamics of financial crises, and going through all the
stages in the figure helps students get the big picture of what is happening during financial crises.
The chapter ends with a discussion of where financial regulation might be heading in the
aftermath of the global financial crisis. Instead of lecturing on this issue, I have the students
themselves speculate on what measures may be needed to prevent a crisis like this from
happening again. This gets them to apply the concepts in the chapter and makes for a very
spirited discussion.