222 PA R T I I I Financial Institutions their many short-term liabilities denominated in foreign currencies The sharp increase in the value of these liabilities after domestic currency devaluation led to further deterioration in bank balance sheets Under these circumstances, the banking systems would have collapsed in the absence of a government safety net as occurred in the United States during the Great Depression With the assistance of the International Monetary Fund, these countries were in some cases able to protect depositors and avoid a bank panic However, given the loss of bank capital and the need for the government to intervene to prop up the banks, the banks ability to lend was nevertheless sharply curtailed As we have seen, a banking crisis of this type hinders the ability of the banks to lend and also makes adverse selection and moral hazard problems worse in financial markets, because banks are less capable of playing their traditional financial intermediation role The banking crisis, along with other factors that increased adverse selection and moral hazard problems in the credit markets of Mexico, East Asia, and Argentina, explains the collapse of lending, and hence economic activity, in the aftermath of the crises Following their crises, Mexico began to recover in 1996, while the crisis countries in East Asia tentatively began to recover in 1999, with stronger recovery later Argentina was still in a severe depression in 2003, but subsequently the economy bounced back In all these countries, the economic hardship caused by the financial crises was tremendous Unemployment rose sharply, poverty increased substantially, and even the local social fabric was stretched thin For example, after their financial crises, Mexico City and Buenos Aires became crime-ridden, while Indonesia experienced waves of ethnic violence S U M M A RY A financial crisis occurs when a disruption in the financial system causes an increase in asymmetric information that makes adverse selection and moral hazard problems far more severe, thereby rendering financial markets incapable of channelling funds to households and firms with productive investment opportunities, and causing a sharp contraction in economic activity Six categories of factors play an important role in financial crises: asset market effects on balance sheets, deterioration in financial institutions balance sheets, banking crisis, increases in uncertainty, increases in interest rates, and government fiscal imbalances There are several possible ways that financial crises can start in advanced countries like Canada and the United States: mismanagement of financial liberalization and innovation, asset-price booms and busts, spikes in interest rates, or a general increase in uncertainty when there are failures of major financial institutions The result is substantial worsening of adverse selection and moral hazard problems that leads to contraction of lending and decline in eco- nomic activity The worsening business conditions and deterioration in bank balance sheets then triggers the second stage of crisis, the simultaneous failure of many banking institutions: a banking crisis The resulting decline in the number of banks causes a loss of their information capital, leading to a further decline in lending and a downward spiral in the economy In some instances, the resulting economic downturn leads to a sharp decline in prices, which increases the real liabilities of firms and therefore lowers their net worth, leading to debt deflation The decline in firms net worth worsens adverse selection and moral hazard problems so that lending, investment spending, and aggregate economic activity remain depressed for a long time The financial crisis of 2007 2008 in the United States that led to a number of banking crises throughout the world was triggered by mismanagement of financial innovations involving subprime residential mortgages and the bursting of a housing-price bubble Financial crises in emerging-market countries develop along two basic paths: one involving the mismanage-