Financial Crises Occur When Financial Systems Become Illiquid

or insolvent. Such crises have recurred throughout the history of capitalism. A collapse in investor confidence, usually after a period of market euphoria, marks such crises—examples include the Dutch tulip mania crisis of 1637–38, the Indian cotton futures market crash of 1866, and the Great Depression of 1929. When foreign lenders are involved, cross-border payments problems arise as well. The East Asian crisis belongs to the class of twin financial crises, involving both banking and currency problems. According to modern economic theory, information asymmetries and financial market failures are central in explaining macroeconomic fluctuations and financial crises.1 Because lenders know less than borrowers about the use of their funds and cannot compel borrowers to act in the lenders’ best interests, lenders can panic and withdraw their funds when they perceive increased risks, in the absence of adequate public regulation and safeguards. That can trigger