Fiscal Space and the Aftermath of Financial Crises: How It Matters and Why

In a sample of 30 countries during the period 1980-2017, those with lower debt-to-GDP ratios responded to financial distress with much more expansionary fiscal policy and suffered much less severe aftermaths. Two lines of evidence together suggest that the relationship between the debt ratio and the policy response is driven partly by problems with sovereign market access, but even more so by the choices made by domestic and international policymakers. First, although there is some relationship between more direct measures of market access and the fiscal response to distress, incorporating the direct measures attenuates only slightly the link between the debt ratio and the policy response. Second, contemporaneous accounts of the policymaking process in episodes of major financial distress show a number of cases where shifts to austerity were driven by problems with market access, but show at least as many where the shifts resulted from policymakers' choices despite an absence of difficulties with market access. These results point to a twofold message: conducting policy in normal times to maintain fiscal space provides valuable insurance in the event of a financial crisis, and domestic and international policymakers should not let debt ratios unnecessarily determine the response to a crisis.