Sunday, October 13, 2013

Credit, Crises, and Consequences

"What the crisis made abundantly clear is that private and public debts cannot be looked at only in isolation," say the authors of "Sovereigns Versus Banks: Credit, Crises, and Consequences." In this working paper, Òscar Jordà, Moritz Schularick, and Alan M. Taylor study the co-evolution of public and private sector debt in advanced countries since 1870. To do so, they use a new dataset covering 17 countries and 140 years.

Source: Jordà, Schularick, and Taylor

First, they find that total economy debt levels have risen a lot over time, but most of the increase has come from the private sector. The key public sector debt event was World War II (see the peak in Figure 1). Averaging across 17 advanced countries,  the ratio of public debt to bank assets went from 3/4 in 1928, to 1/2 in 1967, to 1/3 in 2008. Private borrowing is strongly pro-cyclical whereas public debt is usually mildly counter-cyclical.

Next, they classify recessions as either "normal" recessions or recessions associated with a financial crisis, and examine the cyclical public and private debt patterns associated with each. They find that private credit booms, not public debt booms, are the main precursors of financial instability.  While public sector debt has little influence on whether a financial crisis will occur, it does seem to matter for the speed of the recovery after a financial crisis. High levels of public debt are correlated with slower recoveries, which the authors contribute to fiscal space constraints, or less room to maneuver with fiscal policy.

They are careful to emphasize that high public debt is associated with slower growth only in the aftermath of financial crises. Private credit booms, on the other hand, are associated with slower growth after any type of recession.

Many countries and international bodies are considering or implementing macroprudential rules that incorporate private credit indicators. The authors support this idea in light of their findings. It is also worth considering the causes of the fiscal space constraints and whether, by making them less binding, the slow recoveries from financial crises can be sped up.

4 comments:

  1. I am certainly in agreement that private debt levels can be a valuable indicator for policy, but I am concerned with the interpretation of causation implied in the term "fiscal space constraints."

    There are serious methodological problems with the idea that 17 countries and 140 years of history give enough independent data points to use econometric analysis effectively. Who is to say, for example, that the economic results in the high debt levels following World Wars are strong predictors of growth following high debt levels accumulated for other reasons.

    Financial crises similarly seem highly likely to be dependent on the country's relative standing with other countries. If financial crises are particularly likely to spark contagion that brings down all advanced countries at once, it is very possible that they are working as a proxy for "global recession" vs. "local recession," rather than showing that they have fundamentally different characteristics. The likelihood of spurious correlation in this type of data set is extreme, and the results seem unlikely to shed more light than a simple historical description of circumstances.

    There is also a strong case for reverse causation, where countries that are experiencing a run of weak recoveries (e.g. 90s and 00s Japan and the United States) are more likely to find themselves with fiscal constraints and more likely to have weaker recoveries. This would indicate that weak recoveries come in bunches and that apparent fiscal constraints are selecting for those bunches.

    Finally, we have seen over and again that actual fiscal space constraints and perceived fiscal space constraints differ drastically in the aftermath of financial crises. Japan in particular has shown that its apparent fiscal space constraints were mere illusions, as it has seen little punishment for driving its peacetime debt levels to unprecedented levels. Politics in these situations would provide an independent dimension of policy constraint that would be difficult to catch in any econometric analysis.

    This is certainly an interesting area of research, and I appreciate your bringing it to our attention. I do no necessarily disagree with the main thrust of the conclusions, but I have serious questions about the methodology to reach them.

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  2. Now, this shed a light on what's going on in US.

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  3. Credits should be in line with how much a nation earns.

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  4. Having an income insurance is also important in this type of economy.

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Comments appreciated!