Question

Write about the financial crisis in history. especially about the South Sea Bubble and the Latin American Crisis. Explain why the crisis happen? what were the causes of both crises? what were the results or effects? and After the crisis how the country recover from it?

Note: please write in your own words; do not copy and paste from online sources. the answer has to be in at least 250-300 words

Answer 1

Why does crisis happen?

In my view, Financial crises normally start with the systematic underpricing of risk. Then it results in a significant misallocation of capital that if it is not checked it can lead to speculative bubbles.

At the epicenter of such risks are banks. Why? Because they play a significant role in capital formation and allocation. Due to the relation of the capital markets and economies around the world, risk can be distributed throughout the world. But if it is not taken care of it can lead to financial disasters.

Along with that, banks are highly leveraged and are in business due to the confidence that they have with their depositors. Because they are responsible for capital flows, Banks’ primary activities are the lifeblood of the global economy.

South sea bubble

The South Sea Company was formed in 1711 more or less by Robert Harley. South sea was promised a monopoly of all trade in return for taking over the national debt raised during the War from 1701-1714. However, this was closely dependent on the outcome of the war.

The war ended in 1713, but it diminished the extent of trade possibilities for the Company because of Spain’s autonomy over its colonies.

But then the company effectively persuaded the British government to convert portions of the national debt into South Sea Company shares. The company in 1719 proposed to take over three-fifths of the national debt (about £30 million) in return for trading privileges and accepting 5 percent interest till 1727 and after that 4 percent. Extreme speculation happened and its shares rose from 130 percent to over 1,000 percent in six months.

The South Sea Bubble was not an isolated bubble event. As the South Sea Bubble was beginning, a general interest in joint-stock investment opportunities was also picking up speed. By the middle of 1720, the market was swamped with a remarkable range of new ventures, each creating smaller bubbles as the speculative rage mounted. South Sea Company stock benefited from the investor obsession.

In 1721 formal investigations exposed a web of deceit, corruption, and bribery that led to the prosecution of many of the major players in the crisis, including both company and government officials. Panic selling ensued and the market collapsed, ruining thousands of investors.

The practical steps that were taken after the crash are-. One issue concerned the redistributive effects of the crash. Where arrangements were judged to be inequitable, some attempts were made to alter contracts ex-post. The second goal was to ensure the stability of the economic system. A variety of measures were taken which helped to restore confidence in the system. Thirdly, there was political pressure to find the causes of the crash.

Latin American crisis

The main reason for the debt crisis points to the two large oil price shocks during the 1970s that created current account deficits in many Latin American countries. But at the same time, these shocks created current account surpluses among oil-exporting countries, and the US government encouraged these account surplus countries to park their funds with large US banks and then lending those funds to Latin America.

Latin American borrowing from US commercial banks increased during the 1970s. At the end of 1970, the total outstanding debt from all sources totaled only $29 billion, but that number had skyrocketed to $159 billion and then to $327 billion by the end of 1982.

Nominal interest rates rose globally and commercial banks began to shorten re-payment periods and charge higher interest rates for loans. The Latin American countries soon found their debt burdens unsustainable.

The spark for the crisis occurred in August 1982, when Mexico declared that it would no longer be able to service its debt, which at that point totaled $80 billion. Other countries quickly followed suit.

In response, many banks stopped new overseas lending and tried to collect on and restructure existing loan portfolios. The abrupt cut-off in bank financing plunged many Latin American countries into a deep recession.

The United States stepped in as an international lender of last resort. US commercial banks agreed to restructure the countries’ debt, and the IMF and other official agencies lent the Less Developed Countries(LDC) sufficient funds to pay the interest, but not principal, on their loans. Then LDCs agreed to undertake structural reforms of their economies and to eliminate budget deficits. In a hope that these reforms would enable the LDCs to increase exports and generate the trade surpluses and dollars necessary to pay down their external debt.