"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.