Why financial crises accelerate?

Over-leveraged borrowers imperil the financial system in economic downturns.

The bottom 50% of the population has lost almost all their wealth. They maintained their spending by raising debt.

In normal times, whether the source of spending is income or debt, does not matter. Nonetheless, debt magnifies output deviations in crises.

To maintain expenditure without creating new debt, authorities will have to transfer income into low and mid income groups.

Financial Crises Since 19th Century

Financial crises have been a recurring feature of modern capitalism, but their frequency, severity, and global synchronization have intensified over time. By extending the analysis back to the 19th century, we can identify structural shifts in the global financial system that have made crises more frequent and severe since the 1970s. This report draws on Harvard’s Financial Crises Database (Reinhart & Rogoff, 2009) and complementary historical research to track the evolution of financial instability.

Key Characteristics (1800–1914)

• Gold Standard Era: Fixed exchange rates facilitated trade but constrained monetary policy.

• Colonial Finance: European capital flows funded infrastructure in the Americas and Asia, leading to sovereign defaults (e.g., Latin America in the 1820s, 1870s).

• Banking Panics: Frequent but localized (e.g., Panic of 1873, Baring Crisis 1890).

Crisis Frequency (1800–1914)

Type	Number	Notable Examples
Sovereign Defaults	~50	Greece (1826), Mexico (1860s)
Banking Crises	~30	U.S. (1837, 1873, 1893)
Currency Crises	~40	Latin America (1890s)

Why Less Systemic?

• Limited financial integration (compared to post-1970s).

• Smaller banking sectors (less leverage).

• No "too big to fail" banks (failures were localized).

The Interwar Period (1914–1945): Instability & Policy Mistakes

• Collapse of Gold Standard (1930s) → Competitive devaluations.

• Great Depression (1929–1939) → Global banking collapses (U.S., Europe).

• Rise of Protectionism (Smoot-Hawley Tariff, 1930) worsened trade shocks.

Crisis Frequency (1914–1945)

Type	Number	Notable Examples
Banking Crises	~20	U.S. (1929–1933), Austria (1931)
Sovereign Defaults	~15	Germany (1923 hyperinflation)
Currency Crises	~25	British pound (1931), French franc (1936)

Why More Severe?

• Policy failures (tight money, bank runs, trade wars).

• Lack of lender of last resort (Fed failed in 1929–1933)

The Bretton Woods Era (1945–1971): Relative Stability

• Fixed Exchange Rates (USD-gold peg) → Reduced currency volatility.

• Capital Controls → Limited speculative flows.

• Strong Bank Regulation (Glass-Steagall, Basel norms emerging).

Crisis Frequency (1945–1971)

Type	Number	Notable Examples
Banking Crises	~10	Italy (1963), U.K. (1970s fringe banks)
Sovereign Defaults	~5	Brazil (1961), Indonesia (1966)
Currency Crises	~12	Sterling crisis (1967), French franc (1968)

Why Fewer Crises?

• Limited financial globalization.

• Strict banking regulations.

• No major credit booms (low household/bank leverage).

  
  

The Post-Bretton Woods Era (1971–Present): Surge in Crises

1. End of Gold Standard (1971) → Floating FX → More volatility.

2. Financial Deregulation (1980s–2000s) → Higher leverage, shadow banking.

3. Globalization of Finance → Faster contagion (e.g., 1997 Asia → 1998 Russia).

4. Rise of Private Debt → Housing/credit bubbles (U.S. 2008, Eurozone 2011).

Crisis Frequency (1971–2020s)

Type	Number	Notable Examples
Banking Crises	~150	U.S. S&L (1980s), Japan (1990s), GFC (2008)
Sovereign Defaults	~90	Latin America (1980s), Russia (1998), Greece (2012)
Currency Crises	~120	Mexico (1994), Asia (1997), Turkey (2018)

Why More Frequent & Severe?

• Leverage: Household, corporate, and government debt surged.

• Interconnectedness: Too-big-to-fail banks → Systemic risk.

• Speculation: Derivatives, algorithmic trading → Flash crashes.

Comparing Crisis Eras (1800–2020s)

Period	Key Features	Avg. Crises per Decade
1800–1914	Colonial finance, gold standard	~15
1914–1945	Great Depression, policy failures	~20
1945–1971	Bretton Woods stability	~8
1971–2020s	Deregulation, globalization, debt	~50

Over-Leveraged Borrowers Are Default-Prone

The global financial system enjoyed a rare period of stability following World War II. As shown in the Harvard Business School's Global Financial Crisis Database (HBS, 2024), the era between 1945 and 1980 witnessed an unprecedented decline in banking crises globally. However, beginning in the 1980s, financial instability re-emerged and has since escalated in frequency and severity. What triggered the return of recurrent crises?

Source: Harvard Business School (HBS), https://www.hbs.edu/behavioral-finance-and-financial-stability/data/Pages/global.aspx

A primary culprit is the growing indebtedness of the private sector. When a large share of income is allocated to servicing debt, borrowers become acutely sensitive to fluctuations in income. Over-leveraged households and firms are forced to cut back spending during downturns, which exacerbates recessions. Since every individual's expenditure contributes to someone else's income, widespread cutbacks lead to sharp contractions in national income and aggregate demand (Mian & Sufi, 2014).

During recessions, borrowers cannot easily smooth income losses with new credit, because banks, fearing capital erosion due to rising delinquencies, become risk-averse and shrink their balance sheets (Gorton & Metrick, 2012). Ironically, if all banks collectively extended credit, defaults would likely decrease. Yet, in a decentralized banking system, each bank acts defensively, intensifying the credit crunch. This cycle continues until state intervention halts the unraveling.

Debt-to-GDP ratios of households and corporations reflect this growing fragility. In the United States, household leverage rose sharply from around 45% in the 1980s to a peak of 98% in 2008, before falling slightly due to post-crisis deleveraging and macroprudential regulation (Federal Reserve, 2023). Meanwhile, corporate debt-to-GDP has followed a similar upward trend, rising from around 45% in 1980 to over 80% in 2023 (OECD, 2023). These ratios underscore that private sector leverage has been breaking new records since the 1980s, making economies increasingly vulnerable to financial shocks

The Root Cause of Financial Crises

The surge in private sector indebtedness is deeply connected to growing income and wealth inequality. Since the early 1980s, the share of income accruing to the top 1% in the U.S. has more than doubled—from under 10% in 1980 to over 20% in 2022 (Piketty, Saez & Zucman, 2018; World Inequality Database, 2024). Simultaneously, the bottom 50% of the population has seen its share of wealth fall close to zero, while the top 1% has captured nearly all wealth gains.

To sustain living standards, lower- and middle-income households increasingly resorted to borrowing. In effect, the wealth accumulated by the top 1% was recycled as debt extended to the rest of society. While this substitution works during expansions, it magnifies downturns. Unlike income, debt obligations are fixed. When income collapses, the burden of debt becomes unbearable, triggering a cascade of defaults and financial instability (Rajan, 2010).

Following the 2008 global financial crisis, authorities moved to restrain household leverage through tighter mortgage regulation and macroprudential oversight. However, credit flowed into the corporate sector instead, keeping aggregate private leverage elevated. As of 2023, non-financial corporate debt stands at 81% of U.S. GDP—close to historical highs (IMF, 2024). If left unchecked, corporate leveraging could be the fault line of the next crisis.

Toward a Sustainable Demand Model

To restore financial stability, policymakers will eventually need to restrain all forms of private leverage—household and corporate alike. But debt limits reduce aggregate demand, making recessions more severe unless alternative sources of demand are introduced. The logical solution is direct income support to low- and middle-income groups. However, because inequality is persistent and structural, such transfers must be permanent to maintain demand without renewed debt accumulation.

The Safe Asset Dilemma

Addressing inequality and leverage alone may not be sufficient. The financial system also faces a structural shortage of safe assets. When households and institutions seek safe stores of value, and governments restrain sovereign debt issuance, asset prices become distorted. This safe asset scarcity inflates bubbles in treasuries and high-rated corporate bonds, pushing investors into riskier alternatives (Caballero, Farhi & Gourinchas, 2017).

A potential solution lies in the introduction of central bank digital currencies (CBDCs). If households could deposit savings directly at the central bank, the demand for safe assets could be satisfied without requiring risky credit intermediation by banks. CBDCs would isolate excess savings from the broader financial system, alleviating pressure on banks to generate new debt to serve as safe assets (Brunnermeier & Niepelt, 2019).

Conclusion

The fragility of the financial system stems not merely from excessive borrowing but from the structural dependence on debt to maintain demand and provide safe assets. Reducing private sector leverage—both household and corporate—is essential to lowering default risk and enhancing resilience during downturns. However, simply constraining debt without offering an alternative store of value and demand mechanism would risk dampening economic activity.

To counter this, the introduction of central bank digital currency (CBDC) is critical. CBDCs can serve as a new form of safe, non-debt financial asset, allowing households and institutions to store value securely without pushing the financial system to create more credit. By isolating precautionary savings from the private credit system, CBDCs ease the pressure on banks to expand balance sheets, enabling aggregate demand to be sustained even in a low-leverage economy.

Thus, private debt constraints must be complemented by CBDC issuance to ensure that reduced borrowing does not translate into reduced expenditure. This dual strategy would decouple income volatility from financial instability, allowing borrowers to maintain spending during recessions without escalating default risk. Over time, the financial system would become less procyclical and more shock-resistant—delivering growth with greater stability.

References

• Brunnermeier, M. K., & Niepelt, D. (2019). On the Equivalence of Private and Public Money. Journal of Monetary Economics, 106, 27–41.

• Caballero, R. J., Farhi, E., & Gourinchas, P.-O. (2017). The Safe Assets Shortage Conundrum. Journal of Economic Perspectives, 31(3), 29–46.

• Federal Reserve (2023). Financial Accounts of the United States: Flow of Funds.

• Gorton, G., & Metrick, A. (2012). Securitized Banking and the Run on Repo. Journal of Financial Economics, 104(3), 425–451.

• Harvard Business School (2024). Global Financial Crisis Database. https://www.hbs.edu/behavioral-finance-and-financial-stability/data/Pages/global.aspx

• IMF (2024). Global Financial Stability Report: Navigating High Leverage. International Monetary Fund.

• Mian, A., & Sufi, A. (2014). House of Debt. University of Chicago Press.

• OECD (2023). Non-Financial Corporations Debt (Indicator). OECD Data.

• Piketty, T., Saez, E., & Zucman, G. (2018). Distributional National Accounts: Methods and Estimates for the United States. Quarterly Journal of Economics, 133(2), 553–609.

• Rajan, R. G. (2010). Fault Lines: How Hidden Fractures Still Threaten the World Economy. Princeton University Press.

• World Inequality Database (2024). https://wid.world/