Interesting article, from 1999, from the Philadelphia Fed.
Historically, financial markets have displayed a tendency to overreact to a deterioration in business conditions. During a downturn, it’s normal practice for financial intermediaries to raise their credit standards and for risk-averse investors to shift out of stocks and bonds into cash and government securities. These actions reduce the amount of credit extended to the private nonfinancial sector and raise interest rates charged on loans. Usually, the cutback in credit does not lead to widespread financial distress, although some firms (and households) go bankrupt. But if the cutback is severe, many firms may fail. Widespread business failures, in turn, may cause the failure of financial intermediaries and lead to further cutbacks in credit and more bankruptcies.
This self-propelled cycle of credit cutbacks and bankruptcies leads to a financial crisis that results in low output, high unemployment, and very low investment.
Why a business downturn becomes a fullblown financial crisis is not fully understood,
but investor pessimism plays an important role. If enough people think that a usiness contraction is about to degenerate into a financial crisis and act accordingly, the crisis will, in fact, materialize: investors, fearing a financial crisis, may withdraw so much cash from banks and other depository institutions that they may force even sound financial institutions to run out of cash and fail.
Furthermore, an economy that suffers one financial crisis becomes prone to suffering
more crises because investors begin to view every downturn with alarm, and their pessimism and fear cause downturns to degenerate into crises more often.
And, the article gives a pretty good review of TFP, which Angus invoked, and Tyler lauded, earlier.