Monday, March 7, 2016

A Financial-Fiscal Trilemma

Financial crises and sovereign debt crises are, of course, not a new phenomenon. But the strong connection between fiscal crises and financial crises is relatively recent, primarily developing since the Great Depression and especially since the 1980s. In a new and ambitious NBER working paper, Michael Bordo and Chris Meissner survey the literature on financial and fiscal crises and their interconnections, providing both a history of thought and a catalog of open questions.

The key to the growing link between fiscal and financial crises, they explain, is the increased use of government guarantees of financial institutions. This means that banking crises are often followed by a rise in the debt-to-GDP ratio that can be partially attributed to costs of reconstructing the financial sector. Based on a synthesis of the research in this area and some preliminary empirical analysis, Bordo and Meissner posit that countries face a “financial/fiscal trilemma.” As they explain:
This financial/fiscal trilemma suggests 43 that countries have two of the following three choices: a large financial sector, a large bailout package, and a strong discretionary reaction to the downturn associated with financial crises. The logic is as follows by way of an example. Assume a country with a large financial sector faces a banking crisis. If so, then the government can provide a bailout package of a size that is commensurate with the size of the financial sector. If so it uses up its fiscal space. Otherwise it could lower the size of the bailout and devote its fiscal space to discretionary fiscal policy. With a smaller financial sector, and the same amount of fiscal space, since the size of the bailout would by definition be smaller, the size of the rise in debt due to expansionary policy could rise (p. 42-43). 
They use data from Laeven and Valencia (2012) on 19 systematic banking crises to estimate the equation:
Fiscal costs refer to the fiscal costs of bailouts in the three years following a crisis. Discretion is the change in debt not due to the fiscal costs of bailouts, also in the three years following a crisis. The estimation results, with standard errors in parentheses, are:

Notice that the estimated coefficients on the fiscal cost and discretion to GDP ratios sum to approximately 1, suggestive of a tradeoff. If the financial sector is smaller, or if the bailout package is smaller, then the change in fiscal costs to GDP ratio is likely to be smaller, which could allow a larger change in the discretion to GDP ratio, hence the "trilemma." The trilemma is illustrated by Figure 5, below. The discretion to GDP ratio is on the y-axis and the fiscal costs of bailout to GDP ratio is on the x-axis. For a given change in the debt to GDP ratio, the regression estimates imply an "iso-line" showing the fiscal costs of bailouts and discretion to GDP ratios that are possible.

Source: Bordo and Meissner (2015)

As further evidence of the trilemma, they present Figure 6, which illustrates that countries with a larger financial sector, as measured by the domestic credit to GDP ratio, tend to have a larger rise in the share of the debt to GDP ratio explained by bailouts.
Source: Bordo and Meissner (2015)
This evidence of a new "trilemma" certainly merits more rigorous empirical evaluation. As the authors note, however, empirical studies of financial and fiscal crises face the challenge of inconsistent classification and measurement. Alternative crisis chronologies lead to contradictory results. Bordo and Meissner thus propose the following:
If economists and policy makers truly believed that crises were an important phenomenon to understand and possibly avoid then it might be the case that an independent crisis dating committee could help set the standard in much the same way the NBER business cycle dating committee works. The advantage of following this model is that the NBER is a respected non-governmental, non-partisan organization. Other organizations such as the IMF are not sufficiently politically independent. If crises are becoming increasingly global and crisis fighting is a global public good, then the importance of such a reform should be obvious. 


  1. When you're tired, you want to relax after a stressful working hours, you need to have time to take care of the kids active.
    Please visit our website and play exciting flash games.Thanks you for sharing!
    Friv 4

  2. Warning: US Economy Is About To Collapse Says…

    It’s shocking but true…

    The world?????????’s biggest economy is about to collapse.

    US dollar is going down and there is no way you can stop it.

    Worst of all? This news has been confirmed by Goldman Sachs and the World Bank also.

    That’s why you need to watch astonishing documentary by American Financial Council.

    >>Watch this shocking Documentary Here<<

    Watch this video before the ruling elite makes it inaccessible.

    The video contains various controversial facts that mainstream media is trying its best to hide from you.

    Watch The video now: >> The Collapse of US Economy exposed<<


    [Mr Mark Fidelman]

  3. We are the best writing company providing Research Writing Service written by native English speakers. Our Buy Essay Writing Service are natives of English speaking countries and have undergone testing from an international language certification board to verify their proficiency in written and spoken English.

  4. Great information, i was searching of this kind of information, thankyou very much for sharing with us. i also have some links to share

  5. Thank you for sharing this article, It is an amazing post, I am really impressed by your post its really useful

  6. Dear Admin, you have shared very informative information with us through your article. this information is very useful for me and you are doing amazing work keep it up. I want also to share something with you. Thank you so much for sharing this and I wish you all the best for the upcoming article., Norton product key

  7. Wow, What an incredible blog you have shared with us, The content quality and the way you have describe it is amazing all information is very useful for me. Thank you so much for such an amazing blog and wish you the best of luck for the next comment and I also want to share some useful links here., Office product key,

  8. Really fun, it's good, but I would recommend a movie site. And online series Let's go in

  9. I am very happy to read your article whenever I read it I found something new and interested information in your blog. Thank you so much for share this informative information with us and all the best for the next comment.,, mcafee activation code,


Comments appreciated!