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The fiscal costs of financial instability revisited

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  • Eschenbach, Felix
  • Schuknecht, Ludger

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 such 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 0191.

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Date of creation: Nov 2002
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Handle: RePEc:ecb:ecbwps:20020191

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Related research

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

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  1. Martin Lettau & Sydney C. Ludvigson, 2004. "Understanding Trend and Cycle in Asset Values: Reevaluating the Wealth Effect on Consumption," American Economic Review, American Economic Association, vol. 94(1), pages 276-299, March.
  2. Case Karl E. & Quigley John M. & Shiller Robert J., 2005. "Comparing Wealth Effects: The Stock Market versus the Housing Market," The B.E. Journal of Macroeconomics, De Gruyter, vol. 5(1), pages 1-34, May.
  3. Eugene White & Frederic Mishkin, 2002. "U.S.Stock Market Crashes and Their Aftermath: Implications for Monetary Policy," Departmental Working Papers 200208, Rutgers University, Department of Economics.
  4. Burkhard Drees & Ceyla Pazarbasioglu, 1995. "The Nordic Banking Crises," IMF Working Papers 95/61, International Monetary Fund.
  5. Alexander Ludwig & Torsten Sløk, 2002. "The Impact of Changes in Stock Prices and House Priceson Consumption in OECD Countries," IMF Working Papers 02/1, International Monetary Fund.
  6. Honohan, Patrick & Klingebiel, Daniela, 2000. "Controlling the fiscal costs of banking crises," Policy Research Working Paper Series 2441, The World Bank.
  7. 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.
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Cited by:
  1. Panayiotis Diamandis & Georgios Kouretas & Leonidas Zarangas, 2006. "Asset allocation in the Athens Stock Exchange: A variance sensitivity analysis," Working Papers 0602, University of Crete, Department of Economics.

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