Recognizing the Bias: Financial Cycles and Fiscal Policy

How Do Public Debt Cycles Interact with Financial Cycles?

“…The asymmetric association between financial and public debt cycles supports the "deficit bias" hypothesis, according to which governments expand deficits to cushion recessions ("bad times") but do not rebuild fiscal buffers fully during recoveries ("good times"). It is consistent with regime-switching VAR findings of Afonso et al ( 2011) and Budina et al (2015) regarding asymmetric reaction of debt dynamics to positive and negative financial shocks. The novelty of our result is that it provides first evidence of "deficit bias" in relation to financial cycles within a duration framework.…”

“…This suggests that the relationship between different phases of financial and debt cycles is asymmetric, which could be driven by procyclical fiscal policies that offset automatic stabilizers in periods of financial recovery. It is consistent with regime-switching VAR findings of Afonso et al ( 2011) and Budina et al (2015) regarding asymmetric reaction of debt dynamics to positive and negative financial shocks.…”

“…Given the close association between the financial markets, real economy and public finances, public debt cycles are also expected to be influenced (IMF, 2015;Jorda et al, 2015). While there is growing evidence on the importance of financial shocks for fiscal accounts (Afonso et al, 2011;Benetrix and Lane, 2013;Budina et al, 2015;Liu et al, 2015), empirical analysis of public debt cycles and their association with financial cycles has not been performed systematically in the past. The purpose of this paper is to contribute to the growing literature on the financial markets-fiscal policy nexus and analyze the main features of public debt cycles, with a specific focus on the impact of boom and bust in the financial markets.…”

“…Despite the close association between financial markets, real economy and public finances, linkages between financial and public debt cycles in the context of a duration framework were not studied systematically in the past. Some studies employed a regime-switching VAR model to analyze the impact of financial shocks on the dynamics of public debt and found evidence of asymmetry: while public debt increases significantly in response to a negative financial shock, it declines only slightly and insignificantly in response to a positive financial shock (Afonso et al, 2011;Budina et al, 2015). The only duration study we are aware of that analyzes public debt cycles is Baldacci et al (2012) 2 , but that paper focuses only on one phase of the cycle -debt contractions -and does not assess the impact of financial cycles.…”

“…The impact of financial cycles on the output (denominator) has been already established in the literature mentioned above. The impact of financial cycle on the nominal debt (numerator) can be direct and indirect (Budina et al, 2015;IMF, 2015). The direct impact comes from the need to rescue banks following banking crises that are often preceded by credit booms (Dell'Arricia et al, 2012) and asset buildups (Crowe et al, 2011).…”