Firstly, when people refer to a financial crisis they could refer to different economic problems.
•Recession – fall in output, negative economic growth and higher unemployment (e.g. Great depression of 1930s, Recession of 2008-09)

•Banking crisis – banks lose money, go bust. Fall in money supply.(e.g. Credit crisis of 2007-08. Bank failures during 1931 in US.)

•Government Fiscal Crisis. When government borrowing increases and markets fear it is not sustainable. Leads to higher bond yields and threat of government default. E.g. Greece bond crisis.

•Exchange Rate crisis – rapid fall in value of exchange rate.


Though given options, most likely is probably government fiscal crisis – government debt default. (European fiscal crisis)

Of course, often problems are related. In a recession, government borrowing tends to rise, an economic crisis can lead to a fiscal crisis. In the case of Ireland, the banking crisis got absorbed by the government leading to the fiscal crisis.

Four Options

1. Devalue

This means to reduce the value of your exchange rate. For example, in 1992, the UK was in the ERM. The value of the Pound was semi-fixed against the D-Mark (£1=3DM). But, in September 1992, the government left the ERM and allowed the value of the pound to fall. (see: ERM Crisis) Devaluing exchange rate makes exports cheaper which helps boost growth.

In the case of the Euro, one possibility is for Greece to leave the Euro and restore their own currency. This would lead to an effective fall in their exchange rates and help economy become more competitive.

After financial crisis Iceland devalued Krona by 35% in 2008. This helped Iceland


2. Inflate.

Inflate means to try and boost aggregate demand in the economy to create higher economic growth. For example, in a recession, the Central Bank could cut interest rates, print money or pursue quantitative easing. This leads to an increase in the money supply and can help to stimulate economic activity; it is also likely to cause inflation

This ‘loosening’ of monetary policy can help create higher spending; it may also led to higher inflation (higher prices). It may also be referred to as:
‘expansionary fiscal / monetary policy’ / fiscal stimulus, reflation, ‘kickstart the economy’.

Higher inflation also makes it easier for the government to pay back its debt. In fact inflating away your debt is seen as a kind of a partial default. The government finds it easier to pay back debt and bond holders lose out because their savings are worth less.

e.g. in 1920s, Weimar Germany printed money to pay war reparations leading to hyperinflation.



3. Default

Default refers to the decision by government to stop repaying part or all of its debt. This will make it difficult for government to borrow in the future, but it means they don’t have to aggressively cut spending to reduce borrowing.

When government borrowing as a % of GDP increases rapidly, it becomes quite difficult to control borrowing. In order to meet interest repayments, and reduce the debt burden, the government may be forced to pursue fiscal austerity (cut spending, increase taxes). However, cutting spending in a recession can make it worse. e.g. the attempts by Greece to cut spending have failed to reduce their budget deficit. The deficit continues to rise and it has created social instability; they are also likely to default anyway. A better option may have been for Greece to admit they were going to struggle to repay deb and default on their bonds earlier. It means investors in Greek bonds would lose some money. However, it gives Greece a chance to enable economic growth and in the long run this may be a better deal for bond holders. Rather than still default, but also have a longer period of economic decline.
•Default explained

Deflate

Deflate refers to policies to reduce inflation. It would involve
•‘Tight’ monetary policy – higher interest rates to reduce spending
•‘Tight’ fiscal policy – spending cuts, higher taxes. Tight fiscal policy also reduces the level of government borrowing.

Deflating the economy will tend to reduce growth and reduce the rate of inflation.

e.g. many countries in the Euro have been trying to solve their fiscal crisis by reducing government spending.

However, it is difficult to solve problem by relying on deflation alone. Deflating economy leads to a painful period of adjustment (lower unemployment lower growth)