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What Is a Financial Collapse?

Mass layoffs result from a financial collapse.
Homelessness is often a result of a financial collapse.
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  • Written By: Gregory Hanson
  • Edited By: Susan Barwick
  • Last Modified Date: 12 November 2014
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A financial collapse occurs when an economy suffers some traumatic shock or series of man-made shocks that cause a massive disruption in normal economic activity, resulting in profound and negative consequences for almost all participants in the economy. Breakdown of normal market relations, deflation or hyperinflation, very serious unemployment, or the collapse of asset prices in certain sectors may occur. Such a collapse will generally lead to years of economic recession or depression and serious hardship. No consensus exists as to what causes or prevents such collapses, and while economists have crafted a variety of theories to explain these events, the differences between crisis events make the task of developing a single theory of economic crisis very difficult.

In a normal, healthy economy, most workers are employed, inflation is present but modest, the price of assets increases predictably over time, and markets effectively connect buyers and sellers. When some part of this system fails, the whole structure of a capitalist economy can come to a halt, and a financial collapse may result. Unemployment deprives the market of demand for products, hyperinflation or deflation damages the ability of buyers and sellers to engage with one another through the market, and so forth.

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Historically, financial systems have collapsed for many different reasons. The Roman Empire suffered from a very serious financial collapse, from which the western half of the empire never really recovered, largely as a result of poor economic planning, reckless debasement of the currency, and hyperinflation. This collapse was so severe that a cash economy essentially ceased to function in the West for centuries.

Financial shocks related to currency pricing, over-leveraging, narrow economic development, and rampant speculation produced major damage to world economic systems in the 1920s. These financial shocks, combined with ineffective governmental responses, led to a period of massive unemployment, deflation, and a general breakdown of the normal functioning of market structures in much of the world. In the United States, this financial collapse led to years of anemic growth, whereas in Germany, it contributed to the social and political events that destroyed the Weimar Republic.

Theories on the origin of such financial catastrophes vary widely. A rough consensus of opinion among moderate economists argues that they tend to result from correctable failures in the basic capitalist economic model, such as improper oversight of markets and banks or failed currency policy. Other economists, especially the market fundamentalists of the Austrian School, contend that the presence of any regulation in the system causes these shocks by disrupting market mechanisms. Economists on the left generally argue that a financial collapse is the result of either deep inequality in the economy, which they contend damages the functioning of markets, or even, in the case of Marxist economists, from the very nature of a capitalist system.

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