BPEA Conference Drafts, March 7–8, 2019 Fiscal Space and the Aftermath of Financial Crises: How It Matters and Why Christina D. Romer, University of California, Berkeley David H. Romer, University of California, Berkeley Conflict of Interest Disclosure: Christina Romer is the Class of 1957 Garff B. Wilson Professor of Economics at the University of California, Berkeley and a former Chair of the Council of Economic Adviser. David Romer is the Herman Royer Professor in Political Economy at the University of California, Berkeley. Beyond these affiliations, the authors did not receive financial support from any firm or person for this paper or from any firm or person with a financial or political interest in this paper. They are currently not officers, directors, or board members of any organization with an interest in this paper. No outside party had the right to review this paper before circulation. The views expressed in this paper are those of the authors, and do not necessarily reflect those of the University of California, Berkeley. FISCAL SPACE AND THE AFTERMATH OF FINANCIAL CRISES: HOW IT MATTERS AND WHY Christina D. Romer David H. Romer University of California, Berkeley February 2019 We are grateful to James Church for assistance with data, to Olivier Blanchard, Janice Eberly, Maurice Obstfeld, James Stock, Phillip Swagel, and seminar participants at the University of California, Berkeley for helpful comments, and to the University of Edinburgh for support during early stages of this project. FISCAL SPACE AND THE AFTERMATH OF FINANCIAL CRISES: HOW IT MATTERS AND WHY ABSTRACT In OECD countries over the period 1980–2017, countries with lower debt-to-GDP ratios responded to financial distress with much more expansionary fiscal policy and suffered much less severe aftermaths. Two lines of evidence together suggest that the relationship between the debt ratio and the policy response is driven partly by problems with sovereign market access, but even more so by the choices of domestic and international policymakers. First, although there is some relationship between more direct measures of market access and the fiscal response to distress, incorporating the direct measures attenuates the link between the debt ratio and the policy response only slightly. Second, contemporaneous accounts of the policymaking process in episodes of major financial distress show a number of cases where shifts to austerity were driven by problems with market access, but at least as many where the shifts resulted from policymakers’ choices despite an absence of difficulties with market access. These results point to a twofold message: conducting policy in normal times to maintain fiscal space provides valuable insurance in the event of financial crises, and domestic and international policymakers should not let debt ratios determine the response to crises unnecessarily. Christina D. Romer David H. Romer Department of Economics Department of Economics University of California, Berkeley University of California, Berkeley Berkeley, CA 94720-3880 Berkeley, CA 94720-3880 [email protected] [email protected] There is enormous variation in macroeconomic performance in the aftermath of financial crises. Recent research finds that the amount of fiscal space countries have before a crisis—that is, the room policymakers have to take action—appears to be an important source of this variation. Countries with low debt-to-GDP ratios when a crisis strikes typically face only modest downturns, while countries with high debt ratios generally suffer large and long-lasting output losses (Jordà, Schularick, and Taylor 2016; Romer and Romer 2018). The apparent mechanism behind this correlation is the obvious one: countries that begin a crisis with ample fiscal space take much more aggressive fiscal action. This includes both financial rescue—bank bailouts, loan and deposit guarantees, and recapitalization of financial institutions—and conventional fiscal stimulus—tax cuts and spending increases (Romer and Romer 2018). Our primary goal in this paper is to understand why a country’s fiscal response to a crisis depends on it prior debt-to-GDP ratio. One possibility is that it reflects constraints imposed by market access. Countries with a higher debt ratio may be less able to take aggressive fiscal action or must move more quickly to austerity than lower-debt countries because investors push sovereign yields to prohibitive levels or refuse to lend to them entirely. Alternatively, the link between the fiscal response to a crisis and a country’s debt-to-GDP ratio may reflect choices by the country or international organizations. For example, policymakers’ ideas may lead them to tighten fiscal policy after a crisis if the debt ratio is high, but not otherwise. Likewise, the views of international organizations such as the European Union (EU) or the International Monetary Fund (IMF) may be tied to the debt ratio, and may drive fiscal policy after a crisis either indirectly (say, through standing EU rules) or directly (through bailout conditionality). We investigate this issue using both statistical and narrative evidence for thirty Organisation for Economic Co-Operation and Development (OECD) countries for the period since 1980. Our finding is that both market access and policymakers’ choices played important roles in the fiscal response to crises over the past 40 years, but choices were somewhat more central. 2 A crucial input into our analysis is the indicator of financial distress derived from narrative documents for 24 OECD countries described in Romer and Romer (2017). We extend the indicator through 2017 and incorporate the six additional countries that entered the OECD between 1973 and 2000. We thereby increase the number of observations covered by our measure by more than 20 percent, and the number where our measure shows positive levels of distress by 50 percent. In addition, the inclusion of countries such as Mexico, South Korea, and Hungary allows us to see if less advanced economies fare differently following crises than more mature ones. Extending the series through 2017 enables a much more complete analysis of the aftermath of the global financial crisis than was possible in our previous study (which ended in 2012). For the most part, we find that the extended series yields similar results to those in our previous paper. The average aftermath of crises remains negative, highly persistent, and of moderate severity. Contrary to what one might expect, the aftermath of crises is somewhat less severe on average in less advanced economies. Consistent with our previous study, we also find that there is tremendous variation in the aftermaths of crises. Indeed, if anything, including a wider range of countries and more years following the 2008 global financial crisis makes the variation even starker. To document the importance of fiscal space for the aftermath of crises and the fiscal response, we run panel regressions of output and the high-employment surplus at various horizons after time t on financial distress at t, including an interaction between distress and prior debt-to-GDP ratio. The interaction term is consistently highly significant and of the expected sign: high-debt countries have larger output losses following a crisis and undertake fiscal contraction rather than expansion. The extensive literature on the impact of tax changes and government spending on output suggests there is a likely causal relationship between these two developments. Likewise, focusing on the 22 episodes of high financial distress in our sample confirms a strong correlation between the size of the fiscal expansion following a crisis and the prior debt-to-GDP ratio. 3 The possibility that the debt ratio matters for the fiscal response to crises because it affects sovereign market access (or because it proxies for market access) can be investigated empirically. Interest rates on government debt, sovereign CDS spreads, and credit-agency ratings are all direct indicators of market access. Likewise, being subject to an IMF or other bailout program likely reflects severe problems with obtaining sovereign funding in private markets. If a country’s debt-to-GDP ratio affects the fiscal response to a crisis through market constraints, including such direct measures of market access (interacted with financial distress) in the panel regressions should greatly weaken or eliminate the predictive power of debt for the fiscal response. It does not. While some of the direct measures of market access do seem to affect the fiscal response to a crisis, the effects are generally moderate and only marginally significant. The interaction effect with the debt ratio, on the other hand, remains significant and quantitatively important when the direct measures of market access are included. That is, countries with little fiscal space as measured by their debt-to-GDP ratio undertake less fiscal expansion following a crisis than their lower-debt counterparts, even controlling for the interest rates on their debt and other obvious indicators of market access. This supports the view that choices play an important role in countries’ fiscal decisions around crises. More evidence on the nature and determinants of the fiscal response to crises can be obtained from narrative sources. In particular, we read the Country Reports of the Economist Intelligence Unit (EIU) for the four years following the start of high financial distress in the 22 crisis episodes in our sample. The EIU reports provide a blend of political and policy information that is particularly useful for deducing the motivation for fiscal actions around financial crises. A systematic reading of the reports shows that in some cases, problems with market access unquestionably led to fiscal contraction despite severe post-crisis recessions. This is the case, for example, in Sweden following its crisis in the early 1990s and in Spain and Italy following the 2008 global financial crisis. Sometimes severe market access problems led to an international bailout, where fiscal policy in the affected countries was then driven partly by the 4 views of the rescue organizations; this was the case, for example, with Mexico following its crisis in the mid-1990s and with Portugal and Greece following the global financial crisis. In many other cases, however, the EIU suggests that the fiscal response to a crisis was driven by the choices of domestic policymakers, and, in the case of some EU countries, by EU rules and ideas. This is always true of post-crisis expansions, which are inherently discretionary. But choices were also often central to post-crisis austerity, such as in the United Kingdom and Austria following the global financial crisis. Indeed, in roughly half the cases of post-crisis austerity, the EIU indicates that policymakers’ ideas were more important than market access. The EIU Country Reports also provide substantial narrative evidence that both market access and policymaker choices were related to the debt-to-GDP ratio. Our analysis of the role of fiscal space in the aftermath of financial crises is organized as follows. Section I discusses the extension of our narrative measure of financial distress, and revisits our basic findings about the average aftermath of financial crises and the variation in outcomes. Section II presents statistical results on the role of the debt-to-GDP ratio in explaining the variation in the aftermath of crises. Section III discusses quantitative evidence on whether the debt-to-GDP ratio matters for the fiscal response to crises because it works through or proxies for market access. Section IV provides narrative evidence on the determinants of the fiscal response following a financial crisis. Finally, Section V discusses our conclusions and the implications of our findings for economic policy. Our study builds on several lines of work. First, it is obviously related to the large, but differently focused, literature on the aftermath of financial crises (for example, Bordo et al. 2001; Reinhart and Rogoff 2009; Romer and Romer 2017; Baron, Verner, and Xiong 2018). Second, Bohn (1998), Mendoza and Ostry (2008), Ghosh et al. (2013), and others investigate how the conduct of fiscal policy varies with the debt-to-GDP ratio. These papers, however, do not address either how the debt ratio affects the policy response to financial crises or the mechanisms through which the debt ratio affects the conduct of policy. Third, work defining and 5 measuring fiscal space (for example, Ghosh et al. 2013 and Kose et al. 2017) is also somewhat relevant to the issues we study. Relatedly, Obstfeld (2013), Elmendorf (2016), and other observers argue that having greater fiscal space can be very valuable in the event of a financial crisis. Our analysis lends strong support to that view. Our work is clearly also related to the voluminous work on the output effects of fiscal policy (see Ramey 2016 for a recent survey). The subset of this literature that examines whether fiscal multipliers are larger when the debt-to-GDP ratio is lower (for example, Perotti 1999 and Ilzetzki, Mendoza, and Végh 2013) is closer to the issues we address. However, our finding that the fiscal policy response to financial crises is expansionary at low debt ratios and contractionary at high debt ratios means that the mechanism through which debt affects outcomes in our analysis is different than in those papers. Finally, the two papers that appear most closely related to our contribution are those by Jordà, Schularick, and Taylor (2016) and Romer and Romer (2018). Both find that the aftermaths of financial crises are far worse in countries with high levels of government debt, and Romer and Romer (2018) find that a likely mechanism behind this link is that the policy response is far more contractionary in high-debt countries. One contribution of this paper is to extend and amplify these findings. But our main focus, which these papers do not address, is on the reasons for the dependence of the policy response on the level of debt. I. PRELIMINARIES In order to analyze the aftermath of financial crises, one needs a reliable indicator of when crises occurred in various countries. We use the scaled index of financial distress in OECD countries derived from narrative records described in Romer and Romer (2017). For this paper, we extend the index through 2017 and incorporate six additional countries. This section describes the extension and briefly discusses its impact on some of our previous results. 6 A. Extending the Measure of Financial Distress Our measure of financial distress has three defining characteristics. One is that it is derived from contemporaneous narrative sources. In particular, it is based on the OECD Economic Outlook, a semiannual review of economic and financial conditions in each OECD country. Since the Economic Outlook is available beginning in 1967, our series on financial distress also begins then. There are two observations per year (corresponding to the two issues of the Economic Outlook), dated approximately June and December. Second, we take as our definition of financial distress Bernanke’s (1983) concept of a rise in the cost of credit intermediation: something makes it more costly for financial institutions to supply credit at a given level of the safe interest rate. It could be an increased external cost of funds due to a widespread loss of confidence; increased costs of monitoring borrowers; or an increased internal cost of funds because of rising loan defaults. Third, we scale financial distress along a continuum. This reflects the reality that, like most things, financial distress is not a 0-1 variable. To do this, we define our measure from 0 (no distress) to 15 (extreme crisis; widespread chaos and paralysis in the financial system). Values of 7 and above roughly correspond to what the IMF and other chronologies would identify as a systemic financial crisis (Laeven and Valencia 2014). In our analysis, we therefore often pay particular attention to episodes where distress reached 7 or more. To construct our measure, we specify detailed criteria for translating OECD analysts’ words into our numerical scale. Since the OECD does not typically talk in terms of the cost of credit intermediation, this involves looking for sensible proxies in the narrative accounts. Does the Economic Outlook discuss funding difficulties for banks, a breakdown in intermediation, or creditworthy borrowers having difficulty getting loans? Does it describe the problems as relatively minor (or perhaps affecting just a small sector of the economy), or severe and widespread? Does it believe that troubles in the banking system are just a risk to the forecast, or central to the outlook? In Romer and Romer (2017, online Appendix A), we describe the criteria