A full-scale financial crisis is triggered by a sharp fall in the prices of a large set of assets that banks and other financial institutions own, or that make up their borrowers’ financial reserves. The cure depends on which of three modes define the fall in asset prices.
The first – and “easiest” – mode is when investors refuse to buy at normal prices not because they know that economic fundamentals are suspect, but because they fear that others will panic, forcing everybody to sell at fire-sale prices. The cure for this mode – a liquidity crisis caused by declining confidence in the financial system – is to ensure that banks and other financial institutions with cash liabilities can raise what they need by borrowing from others or from central banks.
This is the rule set out by Walter Bagehot more than a century ago: calming the markets requires central banks to lend at a penalty rate to every distressed institution that would be able to put up reasonable collateral in normal times. Once everybody is sure that, no matter how much others panic, financial institutions won’t have to dump illiquid assets at a loss, the panic will subside. And the penalty rate means that financial institutions can’t profit from the investment behavior that left them illiquid – and creates an incentive to take due care to guard against such contingencies in the future.
In the second mode, asset prices fall because investors recognize that they should never have been as high as they were, or that future productivity growth is likely to be lower and interest rates higher. Either way, current asset prices are no longer warranted.