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Sensitivity analysis of volatility: a new tool for risk management

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Abstract

This paper conducts a comprehensive analysis of the fiscal costs of financial instability (defined as major asset price changes and including, as extreme cases, financial crises). The study identifies three channels to fiscal accounts: 1) revenue effects on capital gains, asset turnover and consumption tax, 2) bailout costs as asset price declines undermine balance sheets of companies/banks, and 3) second-round effects from asset prices changes via the real economy and via debt service costs. A panel analysis and case studies show that episodes of financial instability increase the variability of fiscal balances. Moreover, fiscal costs are often very large and much larger than assumed in the literature so far with public debt rising by up to 50% of GDP during episodes. These fiscal effects can also serve as a, so far under-emphasised, rationale for the deficit and debt targets in the EU's Maastricht Treaty and Stability and Growth Pact. JEL Classification: H3; H6; E6.

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 191.

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Length: 46 pages
Date of creation: Nov 2002
Date of revision:
Handle: RePEc:ecb:ecbwps:20020191

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Related research

Keywords: Fiscal policies; deficits; asset prices; financial stability; financial crisis.;

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References

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  1. Barry Eichengreen & Michael D. Bordo, 2002. "Crises Now and Then: What Lessons from the Last Era of Financial Globalization," NBER Working Papers 8716, National Bureau of Economic Research, Inc.
  2. Karl E. Case & Robert J. Shiller & John M. Quigley, 2001. "Comparing Wealth Effects: The Stock Market Versus the Housing Market," NBER Working Papers 8606, National Bureau of Economic Research, Inc.
  3. Frederic S. Mishkin & Eugene N. White, 2002. "U.S. Stock Market Crashes and Their Aftermath: Implications for Monetary Policy," NBER Working Papers 8992, National Bureau of Economic Research, Inc.
  4. Martin Lettau & Sydney Ludvigson, 2003. "Understanding Trend and Cycle in Asset Values: Reevaluating the Wealth Effect on Consumption," NBER Working Papers 9848, National Bureau of Economic Research, Inc.
  5. Honohan, Patrick & Klingebiel, Daniela, 2000. "Controlling the fiscal costs of banking crises," Policy Research Working Paper Series 2441, The World Bank.
  6. Alexander Ludwig & Torsten Sløk, 2002. "The Impact of Changes in Stock Prices and House Prices on Consumption in OECD Countries," IMF Working Papers 02/1, International Monetary Fund.
  7. Patrick Honohan & Daniela Klingebiel, 2000. "Controlling fiscal costs of banking crises," Proceedings, Federal Reserve Bank of Chicago, issue May, pages 284-319.
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Cited by:
  1. Panayiotis F. Diamandis & Anastassios A. Drakos & Georgios P. Kouretas & Leonidas P. Zarangas, 2012. "Asset allocation in the Athens stock exchange: a variance sensitivity analysis," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 17(2), pages 167-181, 04.

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