Financial Crisis Explained

March 30th, 2009 | economics -

Readers Question: What is difference between Financial crisis and Economic Crisis.

There is no clear cut distinction as they are closely interconnected.

However, the financial crisis refers to the problems in the finance sector. In particular this involves the mortgage defaults and rise in bank losses leading to a decline in bank lending.

In early 2008, many felt that this financial crisis would be limited to the banking sector and the housing market. However, the shortage of credit has had a very powerful impact on the real economy. Because banks are not lending, investment and consumption have fallen contributing to a serious economic recession. It is this fall in GDP / Economic output which made a financial crisis into an economic crisis.

How Financial Crisis Caused Economic Crisis

Housing Boom and Bust. In the US, cheap credit, inflow of capital from Asia, and lax regulation all contributed to a boom in the US housing market. In particular there was a rise in unorthodox mortgage lending. These sub prime mortgages were often rebundled as mortgage securities which were sold around the world. When mortgage defaults started to rise in US, banks started having to write off bad loans. Banks around the world lost money and so became reluctant to lend. For more: See sub-prime mortgage crisis explained
Bank lending is crucial to modern economy. Many businesses were struggling to refinance loans or take out loans for investment. The effect was a fall in investment and spending in the economy.
The mortgage defaults caused a fall in house prices. The fall in house prices has proved a powerful impact on consumer spending. Housing is the biggest form of wealth so with households seeing a decline in wealth and rise in negative equity, consumer spending has fallen.

How Economic Crisis Aggravated Financial Crisis.

The recession was primarily caused by the credit crunch and falling house prices. However, the economic recession is now aggravating the financial crisis.

Because firms are going bankrupt banks are losing more money and reluctant to lend.
Rising unemployment is causing a rise in repossession rates.
Falling house prices has meant banks lose more when they have to reposses houses