global financial crisis

A regular recession is typically confined to one country or a few closely linked economies. A global financial crisis, however, involves widespread problems across the *global* financial system, affecting multiple countries and institutions simultaneously. UPSC often frames MCQs where a recession in a major economy is presented as a GFC – remember to look for the 'global' interconnectedness aspect.

Moral hazard arises when financial institutions believe they'll be bailed out if they take excessive risks. This encourages reckless behavior because they reap the rewards of success but don't bear the full consequences of failure. A real-world example is the bailout of AIG in 2008. Because AIG was deemed 'too big to fail,' it was rescued by the government, potentially incentivizing other institutions to take on similar risks in the future, expecting similar treatment.

The most common criticism is that the IMF imposes harsh austerity measures (like cutting government spending) on countries receiving financial assistance. Critics argue that these measures can worsen the economic situation, leading to increased poverty and social unrest. This is controversial because while the IMF argues austerity is necessary for long-term stability, opponents say it prioritizes creditors over the well-being of citizens.

Excessive deregulation allows financial institutions to take on more risk and engage in speculative activities without sufficient oversight. This can lead to asset bubbles and excessive leverage. A specific example is the deregulation of the financial industry in the US in the decades leading up to the 2008 crisis. This deregulation allowed banks to create and sell complex financial instruments like mortgage-backed securities with little regulatory scrutiny, contributing to the housing bubble.

Asset bubbles occur when the price of an asset (like housing or stocks) rises far above its intrinsic value, fueled by speculation and easy credit. They're dangerous because when the bubble bursts, asset prices plummet, leading to massive losses for investors and financial institutions. This can trigger a credit crunch and a sharp contraction in economic activity. The US housing bubble in the mid-2000s is a classic example.

Leverage refers to the amount of debt a financial institution uses to amplify its investments. High leverage means more debt relative to equity. Liquidity refers to the ability of an institution to meet its short-term obligations. A bank can be highly leveraged (lots of debt) but still liquid (able to pay its bills). However, high leverage makes an institution *more vulnerable* to liquidity problems during a crisis. The key difference: leverage is about debt; liquidity is about cash flow.

Key legal frameworks include national banking regulations (setting capital requirements and lending standards), securities laws (regulating the trading of stocks and bonds), and international agreements like the Basel Accords (setting standards for bank capital adequacy). These frameworks aim to ensure financial institutions are well-capitalized, transparent, and operate within defined risk parameters.

There are multiple perspectives. Some argue that intervention distorts markets and creates moral hazard, leading to future crises. They advocate for allowing market forces to correct themselves, even if it means short-term pain. Others argue that intervention is necessary to prevent a complete collapse of the financial system and protect ordinary citizens. They believe that targeted interventions, coupled with regulatory reforms, can mitigate the risks of future crises. A balanced response would acknowledge both the potential benefits and drawbacks of government intervention, emphasizing the need for careful planning and execution.

Several developments are concerning: the economic shocks from the COVID-19 pandemic, rising inflation and interest rates, the collapse of Silicon Valley Bank and Signature Bank, and geopolitical tensions like the war in Ukraine. These factors contribute to uncertainty, volatility, and increased risk of financial instability, especially in emerging markets with high debt levels. The IMF has repeatedly warned about these risks.

The interconnectedness of the global financial system means that problems in one country can quickly spread to others through various channels. For example, if a large bank in one country fails, it can trigger a loss of confidence in other banks around the world, leading to a credit crunch. Similarly, trade linkages and investment flows can transmit economic shocks across borders. This contagion effect is a key characteristic of global financial crises.

Critics argue that international cooperation can undermine national sovereignty and force countries to adopt policies that are not in their best interests. They also argue that it can be slow and ineffective due to conflicting national interests. However, proponents argue that international cooperation is essential for managing crises that transcend national borders. They believe that coordinated policy responses and financial assistance can prevent crises from escalating and protect the global economy. A balanced response would acknowledge the challenges of international cooperation but emphasize the need for countries to work together to address shared threats.

Since the 1990s, India has strengthened its financial regulations and built up its foreign exchange reserves. It has also adopted a more cautious approach to capital account liberalization. Key lessons learned include the importance of maintaining macroeconomic stability, managing external debt, and promoting financial inclusion. India's relatively strong performance during the 2008 crisis is often attributed to these factors.