Economic Tsunami

An economic tsunami is a widespread set of economic troubles caused by a single significant event. The downstream effects of economic tsunamis generally spread to broad geographic areas, multiple industry sectors or both.

Economic tsunamis take their name from natural tsunamis, which are abnormally large waves triggered by a disturbance to the ocean floor, such as an earthquake. The resulting wave causes widespread destruction as it reaches shore and floods low-lying coastal areas. Likewise, economic tsunamis generate destructive effects beyond the geographic area or industry sector in which the triggering event takes place. These consequences can illustrate previously undetected connections between parts of the global economy that create a ripple effect only under extreme stress. Depending on the severity of the consequences and the mechanism by which they spread, economic tsunamis can lead to new regulations as markets attempt to adapt to mitigate or prevent a future recurrence under similar conditions.

The 2008 global financial crisis sits among the most prevalent recent examples of an economic tsunami. The subprime mortgage market in the U.S. acted as a trigger in this case, as large investment banks miscalculated the amount of risk in certain collateralized debt instruments. Unexpectedly high default rates led to large financial losses in portfolios with high credit ratings, which triggered massive losses for highly leveraged investments made by financial institutions and hedge funds. The resulting liquidity crunch spread rapidly beyond the subprime mortgage market. In response, the U.S. government took over secondary mortgage market giants Fannie Mae and Freddie Mac, while Lehman Brothers filed for bankruptcy. Losses at Bear Stearns and Merrill Lynch led to acquisitions of those firms by JP Morgan Chase and Bank of America, respectively.

Foreign banks also suffered losses through investments affected by the economic crisis. Iceland’s banking sector suffered a nearly complete collapse following the subprime crisis, tanking the nation’s economy. In the United Kingdom, the British government stepped in to bail out its banking sector. The U.S., U.K. and Iceland all undertook varying degrees of regulatory reform following the crisis. Iceland’s economy essentially reinvented itself to rely more heavily upon tourism than on international banking. The U.S. introduced a range of regulatory controls via the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, as well as the Housing and Economic Recovery Act of 2008. Many of these regulations strengthened oversight of mortgage lending. The U.K. response included introduction of the Financial Services Act in 2012.