An economic crisis is a disadvantageous economic phenomenon. During an economic crisis the prices of investment assets fall sharply, companies and consumers are unable to pay their debts, and financial institutions experience shortages. How do markets behave during an economic crisis and is “crisis investing” possible?
Economic crisis often comes with panic, as investors sell their assets and withdraw money from their savings accounts in fear that they will decrease in value if they remain untouched.
Crisis can affect only financial institutions or the whole economy, regional economy, or the worldwide economy. Left uncontrolled it can lead to recession. Even if certain steps are taken to prevent the crisis, they might not work as intended, so there are no perfect solutions that would stop the economic crisis from happening.
Crisis of the global economy
A financial crisis can have many reasons. For example, it can happen due to overestimation of institutions or assets and escalated by the irrational actions of the investors.
One of the factors that encourage such behaviors are speculation bubbles. A speculation bubble happens when the demand for a certain investment rises, and prices of assets are higher than their objective value suggests. With no real assets to support the high prices, the stock prices cannot hold, and the whole markets corrects them to a reasonable level. It happens across a wide range of assets, investors withdraw their money from uncertain markets which further destabilizes them. That’s how destabilized markets contribute to a crisis.
A high unemployment rate can also be a result of a pending economic crisis or one of its causes. An economic crisis can also happen when high interest rates, bank loans, and the decline in customer spending causes the companies to fire workers in order to survive the economic slowdown. It turns into a downward spiral, as unemployed consumers don’t spend money, leading to lower company income and further reducing the employee numbers. Rising unemployment can also be observed when companies outsource the work to other countries. This type of unemployment is constant and can lead to longer economic instability.
A crisis caused by a natural disaster can also cause an economic crisis. Hurricanes, floods, droughts and epidemies can affect the prices we pay for food in stores. Rising food prices can affect consumer habits and begin a downward cycle, which reduces income of companies and causes unemployment.
Cases of economic crisis
Economies of most countries in the world experienced a crisis at least once. We provide you examples of the biggest and most recent crises:
- The market crash of 1929. The crash, which began on 24.10.1929, caused the collapse in prices after a period of crazy speculations and loans to buy stock. It lead to the Great Depression, the effects of which could be felt all over the world for a few years. One of the reasons for this crash was a critical oversupply of crops, which lead to a sudden drop in prices. In the wake of this crisis, a lot of new regulations and tools to manage the market were introduced.
- The Asian crisis 1997-1998. The crisis began in July of 1997, along with the liquidation of the Thai baht. Having no foreign currency, the Thai government was forced to abandon the ties to the American dollar. The result was a massive devaluation, which spread across the most part of Eastern Asia, hitting Japan, and the rise of debt-to-GDP ratio in Thailand. This crisis lead to the creation of better financial regulations.
- The global financial crisis of 2007-2008. This financial crisis was the biggest economic catastrophe since the Great Depression in 1929. It began with the mortgage crisis in 2007 and turned into a global banking crisis along with the fall of Lehman Brothers bank in September of 2008. Great rescue packages and other means were used to stop the damage from spreading and the global economy entered recession.
The global crisis vs. investors
Investors usually don’t act in accordance with the traditional financial theory, in which everyone acts rationally to maximize their profits. People often act irrationally and let their emotions get the better of them, especially in the times of crisis.
Psychological research shows that people, aside from being less prone to risk, are also more reluctant to suffer losses. This means that people are more likely to suffer emotionally due to loss than take pleasure in gain. That, in turn, leads to the fact that as soon as loss becomes probable, they start to make less calculated decisions, and their tendency to take risks deepens. Unfortunately, taking too much of a risk in order to avoid losses usually just increases the loss.
These emotional bias can stick even until after the crisis is over. In surveys, 93% of Millenials said that they trust the market and their investments less. Because of the crisis, young people don’t show up on the stock markets, as they remind them of the losses suffered due to the economic crisis.
Is it possible to intentionally cause a crisis?
Causing a crisis is perfectly possible. There is proof that artificially created hype on cryptocurrencies caused the speculation bubble to rise in 2017, which resulted in the bubble bursting in December 2017, crashing this whole section of market for nearly 2 years.
In theory, it’s also possible to create such crisis with other assets. The Asian crisis, which we mentioned before, was caused by liquefying the Thai cryptocurrency, which lead to recession in the whole region, which persisted for a year. Historically, an excessive money emission caused hyperinflation in the Weimar Republic in 1919-1923, which caused the drop in real wages and demand.
It is known that it is possible to cause a natural disaster, as we witnessed in the case of the Great Famine in Ukraine (1932-1933). A natural disaster with a suitably large reach would be able to cause a long-term global crisis.
A crisis… who profits from it?
While most investors panic and the asset prices plummet, some may see low prices as an opportunity to buy. Very often fear causes the asset prices to go way below their basic worth, rewarding patient investors, who would allow the prices to return to their expected level. Profiting off of investing during a crisis requires discipline, patience, and , of course, an appropriate capital.
Until just recently the stock market was in the middle of a 6-years-long bull market after the massive recession. Those who did not fall into panic noted that not only the worth of their investment wallet got better, but that they made considerable profits.
The stock market isn’t the only way to invest during a crisis. The great recession also caused the real estate prices to drop as a result of the bubble burst on the estate market. People investing in real estate were able to obtain valuable assets for a price that was considerably lower than usual and, as a result, were able to enjoy attractive profits once the real estate market stabilized.