Financial Crises
Chapter

Chapter 14. How Effective Is Fiscal Policy Response in Financial Crises?

Author(s):
Stijn Claessens, Ayhan Kose, Luc Laeven, and Fabian Valencia
Published Date:
February 2014
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Author(s)
Emanuele Baldacci, Sanjeev Gupta and Carlos Mulas-Granados The authors wish to thank Fabian Bornhorst, Stijn Claessens, Julio Escolano, Mark Horton, Julie Kozack, Paolo Manasse, Krishna Srinivasan, and Steve Symansky for providing very helpful comments on an earlier version of the chapter. They would also like to acknowledge excellent research assistance from Diego Mesa and John Piotrowski.

Countercyclical fiscal policies—comprising discretionary expansionary budget measures and the operation of automatic stabilizers—have generally helped shorten recessions in advanced economies during crisis episodes (IMF, 2009a, 2010a). The evidence is not as clear in emerging market economies, where procyclical spending biases, narrow automatic stabilizers, and limited credit access have constrained governments’ ability to provide fiscal stimulus during adverse economic periods (Kaminsky, Reinhart, and Végh, 2004). Initial fiscal conditions generally play an important role in crisis responses (Alesina and others, 2002) in both advanced and emerging economies. Countries are more likely to adopt countercyclical fiscal policies if sufficient fiscal space existed before the crisis.1 The success of fiscal policy in restoring growth also depends on the role of accompanying macroeconomic policies and on the design of the fiscal stimulus packages, because the size of multipliers varies across government spending and tax measures.2

One of the key findings of the literature is that expansionary fiscal responses lead to sustained economic recoveries after the crisis only when the financial sector’s vulnerabilities are addressed without endangering fiscal sustainability (IMF, 2009c). Crisis resolution measures generally entail costly government restructuring of the private sector’s balance sheet, including the financial sector, which can have a lasting negative impact on public debt levels. Furthermore, government interventions to boost private sector credit and domestic demand could leave the economy exposed to the risk of high inflation and low private investment growth. Therefore, a potential conflict arises between the size of countercyclical fiscal expansions during downturns and their medium-term growth implications.

Against this backdrop the contribution of this chapter is twofold. First, it addresses crisis episodes originating in the banking sector that are of a systemic nature (Laeven and Valencia, 2008, 2010) to assess the effectiveness of fiscal policy in restoring growth during times of distress and in sustaining economic expansion in the postcrisis period. Although studies have been carried out to assess policy responses during recessions (Claessens, Kose, and Terrones, 2008; and IMF, 2009a, 2010b) and the role of fiscal policy to stimulate growth and its limits (Feldstein, 2002), detailed evidence on fiscal policy effects during periods of financial distress is lacking.3 During financial crises, the environment for fiscal policy implementation is made more difficult by the high economic cost associated with the shock. Moreover, financial distress can freeze capital market, making it difficult to access financing for deficit expansion.

Second, it addresses the composition of fiscal policy response to assess its effectiveness during shocks. The composition of fiscal expansions and their impact on crisis length and postcrisis output recovery have not been dealt with in sufficient detail in the literature. However, fiscal policy composition could be expected to play a key role in determining both the likelihood of exiting a crisis and medium-term growth prospects, given that short-term fiscal multipliers differ across fiscal policy instruments. Moreover, tax and spending measures adopted during periods of financial distress can have long-term implications for economic efficiency and productivity growth when the crisis is over and contribute to debt-consolidation success (Galí, Lopez-Salido, and Vallés, 2007; Ghosh and others, 2009; Reinhart and Rogoff, 2009; and Baldacci, Gupta, and Mulas-Granados, 2012).

Therefore, the objective of this chapter is to answer the following questions:

  • To what extent does fiscal policy shorten the duration of systemic banking crisis episodes and strengthen economic growth in the medium term?

  • Does the composition of the fiscal policy response matter for either crisis duration or postshock growth performance?

The chapter is organized as follows: The first section reviews the relevant literature. The second section describes the data and the econometric approach. The third section presents the empirical results and is followed by robustness tests in the fourth section. The concluding section summarizes the results and discusses the key policy implications.

Literature Review

Fiscal Impact of Banking Crisis

Until recently, the study of financial crises typically focused either on historical experiences of advanced economies (mainly the banking panics before World War II), or on more recent episodes in emerging market economies.4 An important strand of this literature deals with the controversial issue of identifying and classifying different types of episodes that occurred in the 20th century. There are two major references in this area.

First, Reinhart and Rogoff (2008a, 2008b, 2009) mark banking crises as two types of events: bank runs that lead to the closure, merger, or takeover by the public sector of one or more financial institutions; and if there are no runs, the closure, merger, takeover, or large-scale government assistance for an important financial institution that marks the start of a string of similar outcomes for other financial institutions. With these criteria, they identify 66 cases that occurred between 1945 and 2007. They find that banking crises lead to sharp declines in tax revenues, as well as to significant increases in government spending. On average, they find that government debt rises by 86 percent during the three years following a banking crisis, and at the end of this period, growth resumes slowly to reach an average annual rate of 2½ percent in the third year after the crisis is over. Laeven and Valencia (2010) show that these conclusions hold for a wider sample of crisis episodes.

The second major reference is the papers by Laeven and Valencia (2008, 2010, 2012), which introduce a new data set on banking crises, with information on the type of policy responses implemented to resolve these crises in different countries and the related fiscal costs. Under their definition, in a systemic banking crisis, a country’s corporate and financial sectors experience a large number of defaults, and financial institutions and corporations face difficulties repaying loans on time. Using this mix of objective data and subjective assessments,5 they identify 124 systemic banking crises for the period 1970–2007, and estimate that fiscal costs net of recoveries associated with these crises average about 13.3 percent of GDP, while output losses average 20 percent of GDP. In Chapter 13 of this book, Laeven and Valencia explain that direct fiscal costs to support the financial sector were smaller in the recent crisis because of swift policy action and significant indirect support from expansionary monetary and fiscal policy, the widespread use of guarantees on liabilities, and direct purchases of assets.

Many authors have also focused on the origins of banking crises. These studies have typically found that crises tend to erupt when the macroeconomic environment is weak, particularly when growth is low and inflation and interest rates are high (Demirgüç-Kunt and Detragiache, 1998; and Collyns and Kincaid, 2003).6 Others focus instead on the consequences of these crises, including the study by Reinhart and Rogoff (2009) cited above.7Claessens, Kose, and Terrones (2008) take the analysis one step further and study recessions caused by credit contractions, those associated with house price declines, and episodes of equity price declines. Their results show that the interaction between macroeconomic and financial variables can play a major role in determining the severity and duration of recessions. Specifically, they find evidence that recessions associated with credit crunches and house price busts tend to be deeper and longer than other recessions.8

Policy Responses to Banking Crises

The analysis of policy responses to these crises constitutes another area of interest for scholars.9 Some studies analyze the types of containment and resolution policies aimed at stabilizing the banking sector during financial crises (Laeven and Valencia, 2008, 2010). Others assess the macroeconomic policy response. Claessens, Kose, and Terrones (2008) and IMF (2009a) find that both monetary and fiscal policy tend to be countercyclical during recessions, credit contractions, and asset price declines, in both advanced and emerging economies. In these episodes, fiscal policy appears to be more accommodative, suggesting a more aggressive countercyclical fiscal stance. They also find that expansionary fiscal policy (proxied by discretionary government consumption) tends to shorten the duration of recessions.10

The lessons from these analyses have stimulated other authors to take a more prescriptive approach. For instance, one paper argues that an optimal fiscal package for mitigating the adverse consequences of financial crises should be large, lasting, diversified, contingent, collective, and sustainable (Spilimbergo and others, 2008). Perotti (2011) and DeLong and Summers (2012) also find that in periods of stagnation fiscal policy stimulus can help sustain private sector growth and remove the negative effects on the economy of private sector deleveraging. However, fundamentals matter: Cottarelli and Jaramillo (2012) and Kumar and Woo (2011) show that high debt levels hamper growth; a result confirmed by Panizza and Presbitero (2012). Baldacci and Kumar (2010) highlight that the main channel through which fiscal deficits may reduce long-term growth is higher interest rates, because economic agents anticipate the effect of future taxes to compensate for current deficits and become less confident about debt sustainability. However, fiscal contractions during recessions can harm growth because fiscal multipliers tend to be positive and high during periods of output decline and financial crises (Baum, Poplawski-Ribeiro, and Weber, 2012; IMF, 2012).

Market Perceptions of High Deficits

The increase in fiscal deficits and public debt linked to fiscal policy expansions during crises has also led to a discussion of financial markets’ perceptions of fiscal sustainability. Ardagna (2009) shows that financial markets value fiscal discipline because interest rates on long-term government bonds and stock market prices worsen considerably in periods of fiscal expansion.11Alper, Forni, and Gerard (2012) highlight that both fiscal fundamentals and global risk factors are important for credit risk, but in periods of fiscal stress and for countries with high debt, growth prospects also matter. In addition, during financial crises risks tend to spill over to other economies reflecting banking sector links and mutual interdependencies across financial systems (Caceres, Guzzo, and Segoviano, 2010).

Composition of Fiscal Policy

Looking at the composition of fiscal policy, Akitoby and Stratmann (2008) show that financial markets react to the composition of the budget in emerging market economies. For example, revenue-based adjustments lower government spreads more than do expenditure-based adjustments, and debt-financed spending increases sovereign risks.12Baldacci, Gupta, and Mulas-Granados (2012) find that when adjustment needs are large, as in many economies in the aftermath of financial crises, debt sustainability is more likely to be accomplished through a combination of expenditure and revenue measures, rather than expenditure cuts only. Baldacci, Gupta, and Mati (2011) also highlight that the composition of fiscal policy affects government spreads, but debt levels matter too. They show that spending on public investment contributes to lower government bond spreads, as long as the fiscal position remains sustainable and the fiscal deficit does not worsen.13

Fiscal stimulus is not the only way to support growth during recessions. Automatic stabilizers also play a role and, depending on their design and size, they can contribute to stabilization. Economies with larger automatic stabilizers require, on average, lower fiscal stimulus to generate the same level of support to the economy. Dolls, Fuest, and Peichl (2010) report that automatic stabilizers absorb 38 percent of a proportional income shock in the European Union, compared with 32 percent in the United States. For an unemployment shock, 47 percent of it is absorbed in the European Union, compared with 34 percent in the United States. According to the authors, automatic stabilizers cushion disposable income, leading to demand stabilization of up to 30 percent in the European Union and up to 20 percent in the United States. However, they report large heterogeneity in the size of automatic stabilizers within the European Union (their size is larger in central and northern European economies).

This chapter builds on the literature to assess the relationship between the composition of fiscal policy response during banking crises, the duration of these episodes, and postcrisis economic performance. Although Laeven and Valencia (2008) report multiple measures of containment and resolution policies, they only use one measure of fiscal policy (the budget balance) and their work is not focused on causal analysis. Subsequent empirical work also proxies the fiscal policy response using government consumption and primary balance indicators (IMF, 2009a, 2009b). Instead, this analysis measures the effectiveness of fiscal policy using the different budget categories (on both the revenue side and the spending side) and the observed characteristics of each episode.

Fiscal Policy During Banking Crises

This section describes the impact of banking crises on budgets. A data set of banking crises from a panel of 182 countries between 1980 and 2012 is constructed following the criteria established by Laeven and Valencia (2008, 2010). Some 140 episodes of banking crises are identified that occurred in 112 different countries (crises occurred up to four times in some countries, as in Argentina).14 Laeven and Valencia’s database is complemented with additional data from the IMF’s World Economic Outlook and Government Finance Statistics, and the Global Financial Database.15

Unlike Laeven and Valencia (2008, 2010, 2012), this analysis not only identifies the start of the crises, but also defines their duration. Laeven and Valencia in Chapter 13 of this book address this shortcoming and provide their own estimation of the duration of the financial crises that they identify.16 Identifying the duration of banking crises is difficult because there is no single financial indicator that is valid for all crises. Nevertheless, regardless of the origins and the characteristics of each banking crisis, an assumption is made that a crisis ends after two consecutive years of real GDP growth greater than ½ percentage point per year.17 For the purposes of this chapter this definition allows a link to be made between the crisis duration and the negative output implications of the crisis. This is consistent with the focus on the effects of fiscal policy responses in restoring economic stability.18 The robustness of the results to a different definition of crisis duration, based on stock market performance, is tested later in this chapter.

The above criteria indicate that banking crises lasted on average for 2.6 years, with 83 percent of the crisis episodes lasting between one and four years, and only one episode lasting eight years (see Figure 14.1). This finding is consistent with the findings of Claessens, Kose, and Terrones (2008), who report an average duration of recessions linked to credit crises of 2½ years. Reinhart and Rogoff (2008a) estimate an average duration for their reduced sample of financial crises of about three years.

Figure 14.1Frequency and Duration of Banking Crises

Source: Authors’ estimates.

Consistent with previous studies, the analysis also finds that banking crises generate large economic costs. Peak-to-trough figures (differences between the worst level of a variable during the crisis and its precrisis value) show that the average GDP growth rate fell by more than 6.2 percentage points during a crisis, general government debt increased by 59 percentage points of GDP, and the budget deficit increased by 3.4 percentage points of GDP (see Figure 14.2).19

Figure 14.2Economic Consequences of Banking Crises

Source: Authors’ estimates.

Note: “Period” is from the precrisis year to the last year of the crisis.

Period changes (differences between the precrisis year and the last year of the crisis) are calculated to assess the behavior of fiscal variables during crisis episodes.20 Results for descriptive statistics are expressed as percentages of GDP (Table 14.1).

Table 14.1Period Change in Fiscal Aggregates: Descriptive Statistics
MeanStandard deviationMinimumMaximumObservations
Change in public debt (percent of GDP)40.6022.5511.1280.34140
Change in budget balance (percent of GDP)−2.825.75−31.3715.45140
Change in public revenue (percent of GDP)2.3813.46−50.2341.63140
Change in tax revenues (percent of total revenues)−1.974.93−16.458.55140
Change in tax from income (percent of total revenues)−2.404.03−13.5811.59139
Change in tax from goods and services (percent of total revenues)2.931.29−5.7213.83139
Change in nontax revenues (percent of total revenues)4.3713.53−48.7537.17140
Change in public expenditure (percent of GDP)5.2013.07−46.9538.25140
Change in public consumption (percent of total expend)2.619.50−34.5535.21140
Change in public investment (percent of total expend)2.586.72−19.2122.37140
Source: Authors’ estimates based on data from IMF World Economic Outlook and Global Financial Statistics.
Source: Authors’ estimates based on data from IMF World Economic Outlook and Global Financial Statistics.

During banking crises, fiscal deficits increased by almost 3 percentage points and public debt worsened by 40 percentage points of GDP. Total revenues increased by 2 percentage points during the crisis period, despite the heavy fall in tax revenues because they were offset by nontax revenues. But government expenditures rose by more than 5 percentage points of GDP.21

The Effectiveness of Fiscal Response

In a standard Keynesian framework, a fiscal expansion driven by cuts in taxes and increases in public spending would be expected to shorten the duration of the crisis and sustain medium-term growth. Higher government spending and lower taxes help boost aggregate demand during downturns associated with banking crises, replacing falling private consumption as a growth engine (Arreaza, Sorensen, and Joshua, 1999). Public investment measures can, at least in part, offset the collapse in private investment (Aschauer, 1989). A simple plot of changes in levels of these variables as ratios to GDP against the duration of banking crisis episodes supports these hypotheses.22Figure 14.3 and Table 14.2 show a strong positive correlation between higher deficits and shorter crisis duration. However, budget composition changes matter as well as the size of the fiscal package (see Table 14.3). Higher public consumption (as a percentage of total expenditures) and lower income taxes (as a percentage of total revenues) also shorten the duration of banking crises. The contribution of higher public investment in reducing the crisis length is, however, significantly weaker. Instead, its role is much higher in increasing postcrisis economic growth (see Table 14.4); this confirms previous findings pointing to larger multipliers for public investment than public consumption (Spilimbergo, Symansky, and Schindler, 2009).

Figure 14.3Fiscal Policy and Duration of Banking Crises

Source: Authors’ estimates.

Table 14.2The Relationship between Government Balance and Duration
Duration of crisis
Coefficientt-statisticR-squaredObservations
Change in the budget balance over crisis episode0.071***3.350.075140
Expansionary budget balance (Laeven and Valencia, 2008)1.033***−4.160.111140
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Table 14.3The Relationship between Composition of the Budget and Duration
Duration of crisis
Coefficientt-statisticR-squaredObservations
Change in total public expenditures over crisis episode−0.042***−4.720.139140
Change in public consumption (percent of total expenditures)−0.042***−3.330.074140
Change in public investment (percent of total expenditures)−0.075***−4.240.115140
Change in total public revenues over crisis episode0.043***−5.040.155140
Change in tax revenues (percent of total revenue)0.099***4.100.109140
Change in tax from income (percent of total revenues)0.128***4.330.121139
Change in tax from goods and services (percent of total revenues)0.078*1.820.024139
Change in nontax revenues (percent of total revenues)−0.042***−4.840.145140
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Table 14.4The Relationship between Composition of the Budget and Post-Growth
Average Growth (t through t + 5)
Coefficientt-statisticR-squaredObservations
Change in total public expenditures over crisis episode0.098***4.570.132140
Change in public consumption (percent of total expenditures)0.4301.370.014140
Change in public investment (percent of total expenditures)0.283***7.550.293140
Change in total public revenues over crisis episode0.088***4.220.115140
Change in tax revenues (percent of total revenues)0.081−0.430.001140
Change in tax from income (percent of total revenues)−0.253***−3.540.084139
Change in tax from goods and services (percent of total revenues)0.317***3.200.07139
Change in nontax revenues (percent of total revenues)0.081***3.860.097140
Source: Authors’ estimates.Note: Post-Growth defined as average GDP growth rate during the next five years after end of the crisis.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Source: Authors’ estimates.Note: Post-Growth defined as average GDP growth rate during the next five years after end of the crisis.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.

To test if fiscal expansions reduce the duration of financial crises, and following Laeven and Valencia (2008) an indicator is created labeled Fiscal Expansion.

The following model is used to determine the effect of fiscal policy and other accompanying measures on the duration of banking crises

in which t refers to the entire span of the banking crisis episode and t − 1 refers to the year preceding the onset of the crisis. Fiscal Expansion is an indicator of fiscal expansion equal to 1 if the budget balance worsens by more than 1½ percent of GDP in the first three years following the onset of the crisis, and is equal to zero otherwise. Credit Boom is a dummy variable equal to 1 if the banking crisis was preceded by an abnormal expansion of credit, and is equal to 0 otherwise; and Dep Guarantee is a dummy variable equal to 1 if there was a freeze on deposits or a blanket guarantee in the initial phases of the banking crisis.23 Finally, two measures of resolution policies are included, captured by the total N. Banks Closed during the episode and the degree of Govt Intervention in the financial sector.24

The dependent variable is discrete, and takes values ranging from one year to eight years. A baseline model is estimated in a truncated sample of 140 episodes of banking crises, using ordinary least squares and ordered logit.25 Results are reported in Table 14.5 and show that fiscal expansions are a decisive factor for reducing the duration of banking crises. Based on these results, the average fiscal policy response in the sample reduces the crisis length by more than two quarters.

Table 14.5The Relationship between Fiscal Policy, Resolution Policies, and Duration
Duration (ordinary

least squares)
Duration

(ordered logit)
(1)(2)(3)(4)
Change in budget balance (percent of GDP)0.537***0.083***
−2.98−2.62
Expansionary fiscal policy0.665***−0.932***
(−3.03)(−2.63)
Previous credit boom0.829***0.755***1.217***1.113***
−4.04−3.65−3.67−3.33
Deposit freeze or guarantee−0.608***−0.603***−0.766**−0.714**
(−2.89)(−2.87)(−2.32)(−2.15)
Number of banks closed−0.163***−0.147***−0.394***−0.374***
(−3.40)(−3.03)(−4.49)(−4.27)
Government intervention−0.632***−0.690***−0.827**−0.894**
(−2.95)(−3.24)(−2.39)(−2.59)
Constant3.424***3.728***
−15.35−14.61
Observations139139139139
Adjusted R-squared/pseudo R-squared0.3570.3580.1550.154
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.

The variables capturing the role of the accompanying policies have the expected coefficient signs and are statistically significant. Crises tend to be shorter when fiscal expansions are accompanied by decisive actions to guarantee deposits (reduction in crisis length of two to four quarters) and to close failed banks (reduction in average crisis length of about one year). Crises last about one year longer when preceded by credit booms leading to banking sector vulnerabilities and asset bubbles.26

The model is then estimated to capture the role of budget composition:

Results are reported in Table 14.6 and confirm that a fiscal expansion helps reduce the duration of banking crises.27 An increase in the share of public consumption in total expenditure reduces the duration of crisis episodes because it stimulates aggregate demand.28 An increase of 5 percentage points in this composition variable reduces the crisis length by almost three months. The size of the estimated coefficient for public investment is similar, although its statistical significance is weaker. The results further indicate that governments can actually choose between expenditure-based and revenue-based fiscal expansions because a declining share of revenues from income taxes or taxes on goods and services also helps shorten the duration of banking crises. The effect of cuts in goods and services taxes is, however, larger than the impact of income tax reductions because the former affect a wider number of taxpayers with likely larger impacts on consumption decisions.

Table 14.6The Relationship between Composition of the Budget, Resolution Policies, and Duration
Duration of crisis (ordinary least squares)Duration of crisis (ordered logit)
(1)(2)(3)(4)(1)(2)(3)(4)
Expansionary fiscal policy−0.602***−0.629***−0.585***−0.654***−0.880**−0.898**0.805**−0.903**
(−2.72)(−2.90)(−2.75)(−2.97)(−2.46)(−2.53)(−2.26)(−2.55)
Change in public consumption (percent of total expenditures)−0.019*−0.017
(−1.70)(−1.02)
Change in public investment (percent of total expenditures)−0.035**−0.041*
(−2.22)(−1.71)
Change in income tax revenue (percent of total revenues)0.086***0.138***
(−3.4)(−3.03)
Change in goods and services tax revenue (percent of total revenues)0.0340.063
(−0.97)… .(−1.09)
Previous credit boom0.728***0.715***0.692***0.741***1.092***1.102***1.087***1.094**
(−3.53)(−3.49)(−3.45)(−3.56)(−3.26)(−3.29)(−3.23)(−3.27)
Deposit freeze or guarantee−0.614***−0.514**−0.479**−0.609***−0.724**−0.605*−0.583*−0.745**
(−2.94)(−2.44)(−2.32)(−2.88)(−2.18)(−1.79)(−1.72)(−2.23)
Number of banks closed−0.137***−0.129***−0.134***−0.141***−0.362***−0.355***−0.340***−0.361***
(−2.82)(−2.66)(−2.85)(−2.86)(−4.09)(−1.79)(−3.86)(−4.07)
Government intervention−0.640***−0.661***−0.748***−0.699***−0.851**−0.880**−1.009***−0.930***
(−3.00)(−3.15)(−3.63)(−3.27)(−2.45)(−2.54)(−2.86)(−2.68)
Constant3.700***3.712***3.867***3.717***
−14.57−14.75−15.48−14.32
Observations139139138138139139138138
Adjusted R-squared/pseudo R-squared0.3670.3760.4070.360.1570.1610.1770.158
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.

As in the previous results, the policy control variables are also statistically significant. Crises preceded by credit booms tend to last longer. And those in which bank deposits are guaranteed tend to be shorter. Closing failed banks and strong government intervention are also beneficial to resolving the crisis. All these results are consistent with historical evidence. Overall, the size of the coefficients show that fiscal variables are as important as other accompanying policies in shortening crisis length.

The effectiveness of fiscal policy during banking crises not only contributes to reducing the length of crisis episodes, it also helps create conditions for promoting economic growth following a crisis. The factors affecting average GDP growth rate in the five years following the end of the crisis are estimated using the following specification:29

This model includes three new variables under a common vector that captures the underlying conditions for the activity of the Private Sector. These variables are expected to have an important effect on medium-term growth. First, the change in private investment during the episode is included as a percentage of total investment to capture the vitality of the private sector in stimulating productivity growth. Second, the cost of financing for companies and households (measured by the average difference between long-term interest rates and interbank interest rates) is included to proxy the cost of capital.30 Last, a dummy (fresh capital injections) from Valencia and Leaven (2008) is included that equals 1 if new capital injections into the banking sector were made as part of the resolution policies.

Results for the growth equation are reported in Table 14.7 and show that fiscal expansions do not have any statistically significant effect on GDP growth in the period following banking crises.31 Changing the composition of government spending through higher public consumption is also not statistically significant; however, an increase in public investment or a reduction in the share of income taxes are both positive for medium-term growth because they boost productivity and eliminate distortions that lead to inefficiency.32

Table 14.7The Relationship between Composition of the Budget, Resolution Policies, and Long-Term Growth
Average growth (t through t + 5) (ordinary least squares)Average growth (t through t + 5) (robust)
(1)(2)(3)(4)(1)(2)(3)(4)
Discretionary expansionary fiscal policy0.072−0.326−0.0720.0780.072−0.326−0.0030.131
−0.110(−0.58)(−0.12)(−0.14)(−0.13)(−0.77)(−0.01)(−0.27)
Change in public consumption (percent of total expenditures)0.001−0.001
(−0.01)(−0.01)
Change in public investment (percent of total expenditures)0.243***0.245***
(−5.93)(−5.54)
Change in income tax revenue (percent of total revenues)−0.170**−0.169**
(−2.30)(−2.41)0.370***
Change in goods and services tax revenue (percent of total revenues)0.370***(−4.15)
(−3.96)
Previous credit boom−0.0780.2450.026−0.102−0.0780.2450.033−0.095
(−0.14)(−0.48)(−0.05)(−0.19)(−0.14)(−0.52)(−0.06)(−0.18)
Deposit freeze or guarantee1.415**0.8551.102*1.415**1.415**0.855**1.091*1.413***
(−2.39)(−1.6)(−1.83)(−2.5)(−2.55)(−1.87)(−1.98)(−2.69)
Number of banks closed0.2030.1250.1740.279**0.203*0.1250.1730.276***
(−1.48)(−1.03)(−1.3)(−2.14)(−1.89)(−1.45)(−1.6)(−2.81)
Government intervention−0.240−0.353−0.137−0.216−0.239−0.353−0.142−0.215
(−0.40)(−0.67)(−0.23)(−0.38)(−0.43)(−0.73)(−0.27)(−0.42)
Change in private investment (percent of total investment)0.4380.8300.1150.0140.4380.830***0.1000.002
(−0.74)(−1.58)(−0.17)(−0.02)(−1.38)(−2.98)(−0.27)(−0.01)
Change in cost of financing1−0.127***−0.075**−0.120***−0.124***−1.274**−0.075−0.121**−0.124**
(−3.35)(−2.19)(−3.23)(−3.47)(−2.12)(−1.36)(−2.03)(−2.21)
Fresh capital injections into financial sector1.270**0.8331.159**1.287**1.270**0.833*1.163**1.279**
(−2.14)(−1.58)(−1.99)(−2.3)(−2.18)(−1.85)(−2.15)(−2.39)
Constant2.168***2.384***2.065***1.901***2.168***2.384***2.035***1.871***
(−2.9)(−3.62)(−2.87)(−2.74)(−3.19)(−4.12)(−2.96)(−3.01)
Observations139139138138139139138138
Adjusted R-squared/pseudo R-squared0.1340.3190.1680.2280.190.3630.2220.278
Source: Authors’ estimates.Note: Dependent variable: Average GDP growth in the five years following the end of the crisis.

The cost of financing variable is an average of the lending interest rates and the interbank interest rates.

*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Source: Authors’ estimates.Note: Dependent variable: Average GDP growth in the five years following the end of the crisis.

The cost of financing variable is an average of the lending interest rates and the interbank interest rates.

*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.

Variables controlling for the origin of the crisis and the accompanying containment and resolution policies lose statistical significance. However, variables capturing the behavior of the private sector are systematically linked with the expected sign to better economic performance. An increase in the share of private investment, a reduction in the cost of financing, and an increase in fresh capital for the banking sector all have positive impacts on medium-term output growth.

Initial fiscal and economic conditions are key to fiscal policy effectiveness during crises. To isolate the potential nonlinear effects of initial levels of public debt and GDP per capita on fiscal policy performance, a new augmented specification is estimated. Two new dummy variables are included: Highly Indebted equals 1 when initial public sector debt as a ratio to GDP is above the sample average; and High GDP per capita equals 1 when initial GDP per capita (in purchasing-power-parity dollars) is above the sample average.33 These variables are included in the equation in isolation and they are also interacted with the indicator of fiscal expansion and the budget composition vector.

Consistent with expectations, the positive impact of fiscal expansions and the budget mix on crisis length weakens substantially when initial conditions are poor (Tables 14.8 and 14.9). Countries with higher debt levels and lower per capita income face a higher probability of exiting banking crises later than countries with stronger initial conditions. However, the impact of fiscal expansions on crisis duration is larger once initial economic and fiscal conditions are accounted for: countries with more sustainable public finances have more scope for countercyclical fiscal responses during banking crises. Although weak fiscal conditions do not affect postcrisis growth, countries with high initial per capita GDP tend to be associated with better economic performance in the period immediately following the crises. In all cases, controlling for initial fiscal and economic conditions leads to higher effects of the budget composition variables on growth.

Table 14.8Robustness Estimations: Explaining Duration and Controlling for Initial Fiscal and Economic Conditions
Duration of crisis
(1)(2)(3)(4)
Expansionary fiscal policy−0.34−0.394−0.322−0.328
(−1.16)(−1.33)(−1.03)(−1.09)
Expansionary fiscal policy × Highly indebted (t − 1)−0.715*−0.672−0.696−0.695
(−1.68)(−1.57)(−1.66)(−1.57)
Change in public consumption (percent of total expenditures)−0.050***
(−2.79)
Change in public consumption × Highly indebted (t − 1)0.041*
(−1.79)
Change in public investment (percent of total expenditures)−0.059**
(−2.38)
Change in public investment × Highly indebted (t − 1)0.031
(−0.97)
Change in income tax revenue (percent of total revenues)0.096***
(−2.70)
Change in income tax revenue × Highly indebted (t − 1)−0.025
(−0.47)
Change in goods and services tax revenue (percent of total revenues)
0.049
(−0.84)
Change in goods and services tax revenue × Highly indebted (t − 1)−0.043
(−0.58)
Previous credit boom0.644***0.668***0.599***0.661***
(−3.1)(−3.22)(−2.89)(−3.07)
Deposit freeze or guarantee−0.633***−0.545**−0.518**−0.676***
(−3.01)(−2.55)(−2.44)(−3.12)
Number of banks closed−0.142***−0.138***−0.149***−0.151***
(−2.95)(−2.84)(−3.04)(−3.01)
Government intervention−0.573***−0.574***−0.709***−0.693***
(−2.68)(−2.62)(−3.30)(−3.16)
Highly indebted (t − 1)0.948***0.939***0.868**0.872**
(−2.8)(−2.76)(−2.58)(−2.44)
GDP per capita (t − 1)−7.28e–06*−5.65E–06−5.83E–06−6.79E–06
(−1.84)(−1.43)(−1.48)(−1.66)
Constant3.577***3.544***3.771***3.654***
(−10.31)(−10.18)(−10.73)(−9.988)
Observations133133132132
Adjusted R-squared0.4090.4050.4230.376
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Table 14.9Robustness Estimations: Post-Growth and Controlling for Initial Fiscal and Economic Conditions
Average growth (t through t + 5)
(1)(2)(3)(4)
Expansionary fiscal policy−0.476−0.48−0.645−0.514
(−0.81)(−0.97)(−1.11)(−0.99)
Expansionary fiscal policy × Highly indebted (t − 1)0.6840.1160.4741.078
(−0.77)(−0.16)(−0.57)(−1.40)
Change in public consumption (percent of total expenditures)−0.025
(−0.60)
Change in public consumption × Highly indebted (t − 1)0.027
(−0.51)
Change in public investment (percent of total expenditures)0.264***
(−5.36)
Change in public investment × Highly indebted (t − 1)−0.04
(−0.64)
Change in income tax revenue (percent of total revenues)−0.155*
(−1.95)
Change in income tax revenue × Highly indebted (t − 1)−0.088
(−0.78)
Change in goods and services tax revenue (percent of total revenues)0.605***
(−5.12)
Change in goods and services tax revenue × Highly indebted (t − 1)−0.343**
(−2.27)
Previous credit boom0.1210.3550.2790.024
(−0.25)(−0.88)(−0.59)(−0.05)
Deposit freeze or guarantee1.256**0.640.855*1.059**
(−2.51)(−1.52)(−1.73)(−2.39)
Number of banks closed0.193*0.1340.1410.278***
(−1.71)(−1.43)(−1.25)(−2.75)
Government intervention−0.346−0.615−0.205−0.527
(−0.69)(−1.431)(−0.416)(−1.190)
Change in private investment (percent of total investment)0.5540.772*0.120.122
(−1.12)(−1.87)(−0.22)(−0.24)
Change in cost of financing1−0.082**−0.021−0.074**−0.062**
(−2.55)(−0.77)(−2.41)(−2.20)
Fresh capital injections into financial sector0.917*0.4870.7760.796*
(−1.82)(−1.17)(−1.61)(−1.8)
Highly indebted (t − 1)0.016−0.110.123−0.774
(−0.02)(−0.18)−0.17(−1.17)
GDP per capita (t − 1)−7.23E–06−8.97E–06−8.41E–06−8.78E–06
(−0.77)(−1.16)(−0.93)(−1.06)
Constant2.758***3.143***2.688***3.125***
(−3.39)(−4.65)(−3.44)(−4.31)
Observations133133132132
Adjusted R-squared0.0870.3750.1610.283
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.

The cost of financing variable is an average of the lending interest rates and the interbank interest rates.

Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.

The cost of financing variable is an average of the lending interest rates and the interbank interest rates.

Robustness Analysis

This section assesses the strength of the above results on the basis of three robustness analyses:

  • A different definition of duration. In the baseline model, the definition of duration is based on GDP growth recovery, which means that the end of the banking crisis can only be registered when output growth resumes. However, this definition may be inappropriate if the banking sector problems are resolved quickly but GDP growth lags because of other cyclical or structural impediments. The opposite can also be true, in theory, because cyclical growth may resume with persistent weakness in the financial sector; therefore, the baseline definition of duration is potentially biased. As an alternative, the end of the crisis is defined as the first year in which the stock market index returns to its precrisis level. Under this definition, episodes’ durations are shorter because the stock market tends to recover faster than real output in the sample. Results of regressions using the alternative definition of crisis length are robust to alternative definitions of duration (see Table 14A.1 in the appendix).34

  • A different measure of discretionary fiscal policy. The index of fiscal expansion created by Laeven and Valencia (2008) and used in the baseline model is appropriate for identifying sizable fiscal expansions (those beyond 1½ percent of GDP). However, this index is incapable of differentiating between fiscal expansions that are discretionary and those that are the unintended result of a dramatic collapse of GDP growth. An indicator of discretionary fiscal policy following Blanchard (1990) is calculated for this analysis.35 Results are reported in Table 14A.2 in the appendix and show that baseline results are consistent with this new formulation.

  • Testing for endogeneity between duration and fiscal policy. Because fiscal policy and output growth are correlated, baseline results could be biased as the result of endogeneity as GDP growth enters the definition of crisis length. To control for this factor, a new model is estimated using a two-stage least squares estimator, including all other independent variables and a measure of liquidity support as instruments. Results in Table 14A.3 in the appendix suggest that the main findings hold.

Conclusion

This chapter assesses the effects of fiscal policy responses during 140 episodes of systemic banking crises in advanced and emerging market economies. The results indicate that timely countercyclical fiscal expansions (resulting from both discretionary measures and automatic stabilizers), accompanied by actions to deal with financial sector weaknesses, contribute to shortening the length of crisis episodes. During crises caused by financial sector distress, fiscal expansions increase the likelihood of earlier exit from a shock episode. Expansionary fiscal policies reduce the crisis duration by almost one year in the sample. These results hold for different definitions of crisis duration and alternative specification and estimation methods. The findings are consistent with recent studies that highlight the importance of countercyclical macroeconomic policies in response to recessions associated with financial sector problems (Claessens, Kose, and Terrones, 2008; and IMF, 2009a, 2009b).

Initial fiscal conditions matter for fiscal performance during shocks. In countries with high precrisis public debt levels, lack of fiscal space not only constrains the government’s ability to implement countercyclical policies, but also undermines the effectiveness of fiscal stimulus and the quality of fiscal performance. In these countries, crises last almost one year longer than they do in low-debt countries and the effect of high public debt on duration offsets the benefits of expansionary fiscal policies. Similar results are found for countries with lower per capita income because poor implementation capacity and high macroeconomic risks limit the scope and the effects of fiscal expansions during crises (Botman and Kumar, 2006). These findings point to the importance of creating fiscal space and enhancing macroeconomic stability in tranquil times to limit the risk of falling into crises and to enhance the effectiveness of policy responses when exogenous shocks hit countries (Tavares and Valkanov, 2001). In emerging market economies, attention needs to be paid to strengthening fiscal institutions, reducing political risks, and improving budget execution capacity to reap the benefits of countercyclical fiscal policies (Baldacci, Gupta, and Mati, 2011).

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 scaling up 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 also less effective than lowering taxes on goods and services. 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 (Spilimbergo and others, 2008; IMF, 2009a).

Initial conditions weigh 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, both to minimize output losses in the short term and to enhance medium-term growth prospects. The advantages of early recovery call 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 because markets perceive the higher future fiscal risks embodied in larger deficits (Balduzzi, Corsetti, and Foresi, 1997; and Uribe, 2006).

The quality of the fiscal stimulus package matters most for postcrisis growth resumption. Fiscal responses relying largely on scaling up the share of public investment in the budget show the largest positive effect on medium-term output growth. A 1 percent increase in the share of capital outlays in the budget raises postcrisis growth by about ⅓ of 1 percent per year. Income tax reductions are also associated with positive growth effects.

The results of the short-term and medium-term impacts of fiscal policy during financial crises highlight a potential trade-off between short-term aggregate demand support measures and medium-term productivity growth objectives in fiscal policy responses to shocks. Implementation lags for government investment, which were documented during the 2007–09 crisis, may be, at least in part, responsible for these results. They also point to the need for careful consideration of the composition of fiscal stimulus packages, given that different short-term and medium-term fiscal multipliers can affect fiscal policy performance during the crisis and in its aftermath (Spilimbergo, Symansky, and Schindler, 2009).

The results of the chapter also call for further research. Economic theory predicts that, in normal circumstances, fiscal expansions tend to crowd out private investment and increase the cost of financing for the private sector. However, the empirical findings presented here indicate that an increase in the share of public investment (as a percentage of total public spending) is compatible with an increase in the share of private investment (as a percentage of total investment) during banking crises, and both can make a positive contribution to long-term growth in the subsequent period. This constitutes very preliminary evidence of the crowding-in effects potentially attributed to expansionary fiscal policy in situations of financial stress (Aschauer, 1989). However, a proper test of this hypothesis was beyond the scope of this chapter.

Appendix
Table 14A.1Robustness Estimations: A Different Definition of Duration Based on Stock Market Recovery
Duration of crisis
(1)(2)(3)(4)
Expansionary fiscal policy−0.859***−0.892***−0.843***−0.883***
(−4.55)(−4.76)(−4.57)(−4.71)
Change in public consumption (percent of total expenditures)−0.069
(−1.15)
Change in public investment (percent of total expenditures)−0.004
(−0.27)
Change in income tax revenue (percent of total revenues)0.051**
(−2.31)
Change in goods and services tax revenue (percent of total revenues)0.008
(−0.28)
Previous credit boom0.384**0.396**0.357**0.386**
(−2.19)(−2.24)(−2.05)(−2.18)
Deposit freeze or guarantee−0.21−0.195−0.138−0.216
(−1.18)(−1.07)(−0.77)(−1.20)
Number of banks closed−0.070*−0.074*−0.069*−0.0756*
(−1.69)(−1.76)(−1.69)(−1.81)
Government intervention−0.373**−0.399**−0.442**−0.415**
(−2.05)(−2.20)(−2.48)(−2.29)
Constant2.949***2.963***3.057***2.981***
(−13.61)(−13.64)(−14.13)(−13.51)
Observations139139138138
Adjusted R-squared0.2750.2680.2970.269
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Table 14A.2Robustness Estimations: Focusing on Discretionary Expansionary Fiscal Policy
Duration of crisis
(1)(2)(3)(4)
Discretionary expansionary fiscal policy−0.484**−0.526**−0.459**−0.530**
(−2.25)(−2.50)(−2.20)(−2.45)
Change in public consumption (percent of total expenditures)−0.020*
(−1.81)
Change in public investment (percent of total expenditures)−0.037**
(−2.34)
Change in income tax revenue (percent of total revenues)0.087***
(−3.40)
Change in goods and services tax revenue (percent of total revenues)0.034
(−0.96)
Previous credit boom0.738***0.723***0.705***0.754***
(−3.55)(−3.51)(−3.48)(−3.59)
Deposit freeze or guarantee−0.597***−0.487**−0.463**−0.590***
(−2.82)(−2.28)(−2.20)(−2.75)
Number of banks closed−0.145***−0.137***−0.142***−0.151***
(−2.98)(−2.81)(−3.02)(−3.05)
Government intervention−0.627***−0.648***−0.740***−0.689***
(−2.91)(−3.06)(−3.55)(−3.19)
Constant3.601***3.618***3.765***3.611***
(−14.55)(−14.76)(−15.41)(−14.22)
Observations139139138138
Adjusted R-squared0.3560.3660.3950.347
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Source: Authors’ estimates.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Table 14A.3Robustness Estimations: Controlling for Endogeneity (two-stage least squares estimations)
Duration of crisis
(1)(2)(3)(4)
Expansionary fiscal policy−0.602***−0.629***−0.585***−0.654***
(−2.72)(−2.90)(−2.75)(−2.97)
Change in public consumption (percent of total expenditures)−0.019*
(−1.70)
Change in public investment (percent of total expenditures)−0.035**
(−2.22)
Change in income tax revenue (percent of total revenues)0.086***
(−3.41)
Change in goods and services tax revenue (percent of total revenues)0.034
(−0.97)
Previous credit boom0.728***0.715***0.692***0.741***
(−3.53)(−3.49)(−3.45)(−3.56)
Deposit freeze or guarantee−0.614***−0.514**−0.479**−0.609***
(−2.94)(−2.44)(−2.32)(−2.88)
Number of banks closed−0.137***−0.129***−0.134***−0.141***
(−2.82)(−2.66)(−2.85)(−2.86)
Government intervention−0.640***−0.661***−0.748***−0.699***
(−3.00)(−3.15)(−3.63)(−3.27)
Constant3.700***3.712***3.867***3.717***
(−14.57)(−14.75)(−15.48)(−14.32)
Observations139139138138
Adjusted R-squared0.3670.3760.4070.36
Source: Authors’ estimates.Note: Instrumented variable: Expansionary fiscal policy; Instrument: Liquidity Support.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
Source: Authors’ estimates.Note: Instrumented variable: Expansionary fiscal policy; Instrument: Liquidity Support.*** significant at 1 percent; ** significant at 5 percent; * significant at 10 percent.
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Creating fiscal space includes bringing public sector debt to manageable levels and improving the composition of liabilities (e.g., by currency and maturity) in the public sector balance sheet.

Fiscal multipliers are typically largest for government consumption, public investment, and transfers to households, whereas they are relatively smaller for indirect taxes (Spilimbergo, Symansky, and Schindler, 2009). Fiscal multipliers can also vary depending on the cyclical position of the economy (IMF, 2012).

Aizenman and Jinjarak (2011) provide a general discussion of the fiscal policy response to the 2007–09 financial crisis in advanced and emerging economies. They show the level and composition of the stimulus packages adopted, but no econometric analysis of their impact on crisis length and growth is attempted.

See Calomiris and Gorton (1991) and Gorton (1988) on pre–World War II banking panics; Reinhart and Rogoff (2008a, 2008b) for an analysis of all post–World War II banking crises in advanced economies; Bordo and others (2001) for an analysis that encompasses both advanced and emerging market economies; and Jácome (2008) on banking crises in Latin America.

Unlike previous work (Caprio and Klingebiel, 1996; and Caprio and others, 2005), they exclude banking system distress that affected isolated banks but was not systemic in nature.

For a review of the literature on the origins of banking crisis, see Lindgren, Garcia, and Saal (1996); Kaminsky and Reinhart (1999); and Dooley and Frankel (2003).

For similar analyses of the real effects of banking crises, see Frydl (1999) and Dell’Ariccia, Detragiache, and Raghuram (2008).

See Spilimbergo and others (2008) for a review of historical episodes of financial crises and the conduct of fiscal policy during the shock period.

For an overview of existing literature on how crisis resolution policies have been used and the trade-offs involved, see Hoelscher and Quintyn (2003) and Honohan and Laeven (2005).

Berg and Ostry (2011) find that the duration of growth spells is also affected by income distribution. Output growth episodes tend to be shorter and less frequent when income inequality is higher.

Afonso and Strauch (2004) obtain similar results using events analysis on a sample of European Union countries.

Revenue-based adjustments along with expenditure efficiency measures are also found to sustain fiscal consolidation episodes in emerging market economies (Gupta and others, 2005).

On financial market reactions to fiscal policy initiatives, and how these developments affect corporate bond spreads, see Durbin and Ng (2005) and Cavallo and Valenzuela (2007).

Laeven and Valencia (2008) identify 124 episodes of banking crises, 208 currency crises, and 63 sovereign debt crises. This analysis uses the data set of 124 banking crises and drops 10 of them because of the lack of fiscal data. That leaves 114 cases, to which were added 4 more cases from Laeven and Valencia’s other two data sets (initially classified as currency crises or debt crises that later triggered banking crises). Finally, the total sample of 140 cases was achieved by including 22 new observations that Laeven and Valencia (2010) added to their updated database, most of which were advanced economies affected by the 2007–09 financial meltdown in the United States and Europe.

They define the end of a crisis as the year before two conditions hold: real GDP growth and real credit growth are positive for at least two consecutive years.

For those episodes of banking crises that are still ongoing, the last year of our sample, 2011, is taken as the final year and IMF projections are used to assess postcrisis GDP growth.

An alternative measure to the one used in the chapter could be the cumulative output loss during the crisis. A strong positive correlation is found between crisis length and output losses during the banking crisis episodes used in the analysis.

Results using alternative measures, such as period changes and period averages, yield similar conclusions, thus, the rest of the chapter focuses on one definition of crisis effects. The robustness of empirical findings to alternative definitions and results still hold. The fiscal balance incorporates the effect of discretionary policy changes (including measures to support the financial system), automatic stabilizers, and other nondiscretionary budget changes. Public debt also incorporates the cost of below-the-line measures to repair the financial system during crises.

The fiscal balance incorporates only “above-the-line” budget measures implemented during the crisis to support the financial sector (e.g., interest rate subsidies) following the Government Finance Statistics methodology. “Below-the-line” measures to help bank recapitalization and support liquidity are included in public sector debt data when governments bear the cost.

The change in government expenditure in part reflects a decline in output, which raises the ratio of spending to GDP. Nonetheless, cyclically adjusted spending also rose in the period, reflecting discretionary fiscal expansion and automatic stabilizers. The rest of the chapter uses fiscal variables expressed as ratios to GDP. The robustness of this assumption is tested by replacing these indicators with cyclically adjusted variables and the results hold.

As in the previous section, all variables are calculated as the change during the period (from precrisis year to last year of crisis). Public consumption and public investment are computed as shares of total expenditures, and tax revenues from income and goods and services are computed as shares of total revenues.

An attempt was made to include other containment policies defined in Laeven and Valencia (2008), but these factors were strongly correlated to the other exogenous variables.

See Laeven and Valencia (2008) for the derivation of these variables.

The ordered logit estimation can be seen as a robust analysis method to control for the influence of outliers (e.g., crises with long duration). This equation was also estimated using a Tobit estimator to account for the nonnegativity of the dependent variable. Results were similar to the ordered logit.

Although the model measures the direct impact of various financial crisis responses, the possibility of more complex dynamic interactions between fiscal variables and other accompanying policies in response to shocks is not ruled out. However, attempts to add interaction terms do not yield significant results. The good fit of the estimated model confirms that other factors, including interactions, would not add much to the explanatory power of the equation.

These results also hold when the budget balance is used instead of the large fiscal expansion indicator. For the sake of space, results are not reported in the chapter but are available upon request from the authors.

As mentioned earlier, the end of the crisis period is defined on the basis of output growth. This is why fiscal measures associated with aggregate demand boost are effective in shortening crisis duration, consistent with the literature on fiscal multipliers (Spilimbergo, Symansky, and Schindler, 2009). This assumption is also tested for robustness using alternative definitions of crisis end based on financial sector performance. Results reported in the next section show that the findings hold under different definitions of crisis duration.

Because this chapter’s focus is on the implications of fiscal responses during shock episodes on postcrisis growth, current fiscal and monetary policy variables are not included in the equation to avoid endogeneity and collinearity among regressors. However, given the potential importance of these factors, the robustness of the results to the inclusion of the coincident fiscal deficit and short-term nominal interest rate is assessed, with the result that conclusions in the text are not affected.

This variable measures the opportunity cost of investing compared to holding liquidity.

Results are confirmed when using the fiscal balance in the place of the fiscal expansion indicator.

This is consistent with previous studies for a sample of crisis and noncrisis episodes (for example, Alesina and others, 2002). The fiscal mix in noncrisis periods is also found to be a significant driver of medium-term financial implications of fiscal expansions (Ardagna, 2009) and the sustainability of fiscal adjustments in emerging market economies (Gupta and others, 2005).

Using alternative thresholds for these variables yields similar results.

This and other robustness results are available from authors upon request.

Blanchard (1990, p. 12) defined this indicator as follows: “the value of the primary surplus which would have prevailed, were unemployment at the same value as in the previous year, minus the value of the primary surplus in the previous year.” Both variables are expressed as a percentage of GDP. When this change was greater than −1½ percent of GDP, the year was labeled as a fiscal expansion (value 1), and zero otherwise.

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