However, these do not hold for countries with limited fiscal space where fiscal expansions are prevented by funding constraints. The composition of countercyclical fiscal responses matters as well for output recovery after the crisis, with public investment yielding the strongest impact on growth.

These suggest a potential trade-off between short-run aggregate demand support and medium-term productivity growth objectives in fiscal stimulus packages adopted in distress times.

These are few of the findings of a study of the IMF by Emanuele Baldacci, Sanjeev Gupta, and Carlos Mulas-Granados. This working paper studies the effects of fiscal policy response in 118 episodes of systemic banking crisis in advanced and emerging market countries during 1980-2008.

The results indicate that timely countercyclical fiscal responses (both due to discretionary measures and automatic stabilizers), accompanied by actions to deal with financial sector weaknesses, contribute to shortening the length of crisis episodes. During crisis caused by financial sector distress, fiscal expansions increase the likelihood of earlier exit from a shock episode. Expansionary fiscal policies reduced the crisis duration by almost one year.

These results hold for different definitions of crisis duration and alternative specification and estimation methods. The findings are consistent with recent studies that highlight the importance of countercyclical policy in response to recessions associated with financial sector problems.

Initial fiscal conditions matter for fiscal performance during shocks. In countries with high precrisis ratios of public sector debt to GDP, lack of fiscal space not only constraints the government’s ability to implement countercyclical policies, but also undermines the effectiveness of fiscal stimulus and the quality of fiscal performance.

In countries with high debt, crises lasted almost one year longer. The effect of high public debt on duration completely offset the benefits of expansionary fiscal policies in these countries.

Similar results are found for countries with lower per capita income, as poor implementation capacity and high macroeconomic risks limit the scope and the effects of fiscal expansions during crises.

These findings point to the importance of creating fiscal space and enhancing macroeconomic stability in tranquil times to limit the risk of falling into crises and to enhance the effectiveness of policy responses when exogenous shocks hit countries.

In emerging market economies, attention needs to be paid to strengthening fiscal institutions, reduce political risks and improve budget execution capacity to reap the benefits of countercyclical fiscal policies.

The composition of fiscal expansions matters for crisis length—a point that has not been studied in the literature. Stimulus packages that rely mostly on measures to support government consumption are more effective in shortening the crisis duration than those based on public investment. A 10 percentage point increase in the share of public consumption in the budget reduces the crisis length by three to four months. Reducing the share of income taxes is less effective than consumption taxes in shortening the length of a banking crisis.

These results suggest that tailoring the composition of fiscal response packages is important for enhancing the effectiveness of countercyclical fiscal measures in both advanced and emerging market economies.

Fiscal expansions do not have a significant impact on output recovery after the crisis though.

Crises can have long-term negative effects, damaging human and physical capital with negative implications for productivity and potential output growth. Early recovery from a crisis is therefore important, to minimize output losses in the short term and enhance medium-term growth prospects. This calls for timely fiscal responses during downturns.

However, fiscal policy responses may not be effective when initial fiscal conditions are poor and fiscal space is limited. High public debt levels and past macroeconomic instability limit the scope for countercyclical deficit expansions and hamper the effectiveness of fiscal stimulus measures as markets perceive the higher future fiscal risks entailed by larger deficits.

The quality of the fiscal stimulus package matters most for post-crisis growth resumption, with fiscal responses relying largely on scaling up the share of public investment in the budget showing the largest positive effect on medium-term output growth. A one percent increase in the share of capital outlays in the budget raised post-crisis growth by about ⅓ of one percent per year. Income tax reductions are also associated with positive growth effects.

The results of the short-term and medium-term impacts of fiscal policy during financial crises highlight a potential trade-off between short-run aggregate demand support measures and medium-term productivity growth objectives in fiscal policy response to shocks.

Implementation lags for government investment, which were documented also during the current crisis, may be, at least in part, responsible for these results. They also point to careful consideration of the composition of fiscal stimulus packages, as different short-term and medium-term fiscal multipliers can affect fiscal policy performance during the crisis and in
its aftermath.

The results of the paper also call for further research. Economic theory predicts that, in normal circumstances, fiscal expansions tend to crowd out private investment and increase the cost of financing for the private sector. However, the empirical findings presented here indicate that an increase in the share of public investment (as a percentage of total public spending) is compatible with an increase in the share of private investment (as a percentage of total investment) during banking crises, and both can have a positive contribution to long-term growth in the subsequent period. This constitutes a very preliminary evidence of the crowding-in effects potentially attributed to fiscal policy in situations of financial stress. But a proper test of this hypothesis was beyond the scope of this paper.#