THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 245

CHAPTER 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