Fiscal Policy and Banking Sector Repair Synergies

From the conclusion to "How Effective is Fiscal Policy Response in Systemic Banking Crises?", by E. Baldacci, S. Gupta, and C. Mulas-Granados:
This paper assessed the effects of fiscal policy responses during 118 episodes of systemic
banking crises in advanced and emerging market economies. The results indicate that timely
countercyclical fiscal responses (both due to discretionary measures and automatic
stabilizers), accompanied by actions to deal with financial sector weaknesses, contribute to
shortening the length of crisis episodes. During crisis caused by financial sector distress,
fiscal expansions increase the likelihood of earlier exit from a shock episode. Expansionary
fiscal policies reduced the crisis duration by almost one year. 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
policy in response to recessions associated with financial sector problems (Classens, Kose,
and Terrones, 2008; IMF, 2009b; IMF, 2009c).

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. Similar
results are found for countries with lower per capita income, as 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, reduce political risks and improve budget
execution capacity to reap the benefits of countercyclical fiscal policies (Baldacci, Gupta,
and Mati, 2008).

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 (Spilimbergo et al., 2008; IMF, 2009).

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
(Balduzzi, Corsetti, and Foresi, 1997; Uribe, 2006).

Correlations are shown in Figure 3 from the paper:

Figure 3: from "How Effective is Fiscal Policy Response in Systemic Banking Crises?", by E. Baldacci, S. Gupta, and C. Mulas-Granados.

This study provides some empirical basis for the argument that fiscal stimulus assists in repairing the financial system. I think it also provides a nice counterpoint to those who obsess on only the real side aspects of the stimulus package (although there are always some who believe that the financial sector is merely a veil and hence irrelevant).