Banking crises, Output Loss and Fiscal Policy

This paper analyses the role fiscal policy plays during banking crises in supporting short-term GDP growth and the growth potential. Using a database covering 56 advanced and emerging economies for the period 1970-2008, it is found that fiscal policy, whether it is expansionary or contractionary, appears to matter for the impact of banking crises on headline growth but not on potential output. The stronger expansionary impact of fiscal policy during banking crises does not seem to be driven by the fact that resources are largely underutilized in those periods. DSGE model simulations help provide an interpretation of these findings. If agents are constrained in their borrowing by the value of their collateral (e.g., Kiyotaki and Moore, 1997), fiscal multipliers during banking crises are higher because the fiscal expansion has the additional effect of increasing the value of the collateral constrained households have, thus boosting demand also via a relaxation of lending constraints by banks.