Thursday, July 30, 2009

Stimulus and Crisis Duration

Menzie Chinn quotes from the conclusion to a new study of the effectiveness of fiscal policy in systemic banking crises. Here are the passages relevant to France's situation:

Initial fiscal conditions matter for fiscal performance during shocks. In countries with high precrisis ratios of public sector debt to GDP, lack of fiscal space not only constraints the government's ability to implement countercyclical policies, but also undermines the effectiveness of fiscal stimulus and the quality of fiscal performance. In countries with high debt, crises lasted almost one year longer. The effect of high public debt on duration completely offset the benefits of expansionary fiscal policies in these countries.


The composition of fiscal expansions matters for crisis length -- a point that has not been studied in the literature. Stimulus packages that rely mostly on measures to support government consumption are more effective in shortening the crisis duration than those based on public investment. A 10 percentage point increase in the share of public consumption in the budget reduces the crisis length by three to four months. Reducing the share of income taxes is less effective than consumption taxes in shortening the length of a banking crisis. These results suggest that tailoring the composition of fiscal response packages is important for enhancing the effectiveness of countercyclical fiscal measures in both advanced and emerging market economies
Fiscal expansions do not have a significant impact on output recovery after the crisis though. Crises can have long-term negative effects, damaging human and physical capital with negative implications for productivity and potential output growth. Early recovery from a crisis is therefore important, to minimize output losses in the short term and enhance medium-term growth prospects. This calls for timely fiscal responses during downturns. However, fiscal policy responses may not be effective when initial fiscal conditions are poor and fiscal space is limited. High public debt levels and past macroeconomic instability limit the scope for countercyclical deficit expansions and hamper the effectiveness of fiscal stimulus measures as markets perceive the higher future fiscal risks entailed by larger deficits.

The paper is "How Effective is Fiscal Policy Response in Systemic Banking Crises?", by E. Baldacci, S. Gupta, and C. Mulas-Granados

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