THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 245

CHAPTER 9
STAGE ONE
Initiation
of Financial
Crisis

Deterioration in
Financial Institutions
Balance Sheets

Fiscal
Imbalances
STAGE TWO
Currency
Crisis

Financial Crises and the Subprime Meltdown 213

Asset Price
Decline

Increase in
Interest Rates

Increase in
Uncertainty

Adverse Selection and Moral
Hazard Problems Worsen

Foreign Exchange

Crisis

Adverse Selection and Moral
Hazard Problems Worsen
STAGE THREE
Full-Fledged
Financial
Crisis

Economic Activity
Declines

Banking
Crisis

Adverse Selection and Moral
Hazard Problems Worsen

Economic Activity
Declines

Factors Causing Financial Crises
Consequences of Changes in Factors

FIGURE 9-3

Sequence of Events in Emerging-Market Financial Crises

The arrows trace the sequence of events during financial crises.

Stage One:
Initiation of
Financial
Crisis

Financial crises in emerging-market countries develop along two basic paths: one
involving the mismanagement of financial liberalization and globalization, and the
other involving severe fiscal imbalances.
PATH ONE: MISMANAGEMENT OF FINANCIAL LIBERALIZATION AND GLOBALIZATION

As occurred in the United States during the subprime financial crisis of 2007 2008,
the seeds of a financial crisis in emerging-market countries are often sown when
countries liberalize their financial systems. Liberalization occurs when restrictions
on domestic financial institutions and markets are eliminated and the economy is
opened up to flows of capital and financial firms from other nations. This is a
process called financial globalization.