The Anatomy of a Financial Crisis and How to Recover from It

While there can be differences in the details, the basic anatomy of financial crises is generally the same. This is according to Dr. Patrick Honohan, a former Governor of the Central Bank of Ireland who is the Central Bank of Barbados’ 4th Distinguished Visiting Fellow.

Speaking to officials from the private sector during a presentation on the topic “Recovering from Crisis: Lessons from Europe”, Honohan asserted that financial crises are usually the result of one or more of three factors: prodigious borrowing by the private sector, especially at times when interest rates are low; excessive borrowing by the public sector; and a loss of competitiveness for the country due to high wages or prices.

Using Europe as an example, Honohan identified countries where each of these factors was principally responsible for a financial crisis. He cited Italy as a country whose challenges were largely the result of a lack of competitiveness, and Greece as one where excessive government played a significant role. Exuberant spending by the private sector, he explained, was the source of Ireland’s troubles.

According to Honohan, financial crises begin with what he termed a “sudden stop”, an abrupt change in the government’s ability to obtain external funding, or to do so quickly. The government then needs to make adjustments in its spending, which potentially has an impact on the country’s level of output and can also necessitate layoffs. Increased unemployment often results in loan defaults, and the general uncertainty about the economic situation can lead members of the public, even those not currently affected, to spend and borrow less. This in turn leads to reduced tax revenue for the government compounded by increased pressure to provide social safety nets for those citizens who are suffering due to the economic downturn. This creates a feedback loop where the effects of the crisis actually compound the crisis.

Honohan maintained that it is possible to recover from crisis, however, and he outlined five strategies that worked in Europe, and Ireland in particular.

He emphasised that early acknowledgement of the depth of the crisis was essential. This allowed the Irish government to act immediately, which allowed it to restore some measure of confidence among creditors. Beyond taking early action, it was important to have coherent medium-term goals, five-year and 10-year plans, that provided direction and further motivation for the country to follow through on the necessary corrective action. He added that seeking assistance from partner countries within the European Union was also important.

Honohan also stressed that having credible forecasting was important as this allowed countries to better monitor their progress. He contrasted the accuracy of Ireland’s forecast when checked against its actual economic performance with the significant deviation between Greece’s five-year performance and what had been projected.

A fifth – and key – component to Ireland’s recovery, Honohan revealed, was its policy of maintaining open communication with the public. During Ireland’s financial crisis, unemployment rose to 15%, public servants’ salaries were cut by an average of 14%, taxes increased (VAT was 23%), and social services were reduced. The Irish public was angry, he admintted, but they were also worldly people who had seen financial crises play out elsewhere and knew that tough measures were necessary. “Adjustments are always painful, but if the public understands them, they might accept them.”

Honohan maintained throughout the session by saying that recovery is a lengthy and difficult process, one that requires governments to make hard decisions and to have the discipline to see them through. As for what does not work, Honohan mentioned three behaviours: procrastination, threats and grandstanding, and rigidity.

2017-03-22