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Sovereigns versus Banks:
Crises, Causes and Consequences
Òscar Jordà *
Moritz Schularick †
Alan M. Taylor ‡
* Federal Reserve Bank of San Francisco and UC Davis
† University of Bonn and CEPR
‡ UC Davis, NBER, and CEPR
Disclaimer: The views expressed herein are solely the responsibility of the authors and should not be interpreted as reflecting
the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System.
Two narratives about debt and crises
Dangers of private sector credit booms:
Solvency/liquidity risk for households/intermediaries
Bursting of private debt boom in US, Spain, UK
Dangers of excessive public borrowing:
Doubts about sovereign debt undermine the financial sector: “doom loop”, “deadly embrace”
Arguably the story in Greece, Italy, Portugal
Which debts should we worry about as the proximate causes of crises?
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Two narratives about debt overhang
Private sector debt overhang
Household debt overhang: Mian/Sufi (2009, 2011)
Balance sheet recessions: Koo (2008), Eggertsson/Krugman
(2012)
Public sector debt overhang Drag from high public debt: Reinhart and Rogoff (2009;2010); Checherita and Rother (2010); Kumar and Woo (2010)
Which debts should we worry about as the source of post‐crisis drag on growth?
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Big questions
Broadly, what are the macroeconomic consequences of private and public leveraging and deleveraging?
What then are the implications for policy?
Macro‐prudential regulation? Fiscal rules? Both?
Economic history has a lot to offer (“rare events”)
The return of large T: Reinhart and Rogoff on public debt and economic performance (TTID etc.)
Our research adds a new focus on private sector credit: Schularick/Taylor (AER 2012); Jorda/Schularick/Taylor (IMFER 2011, JMCB 2013)
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What we do
Based on the near universe of advanced economies’ business cycles since 1870, in this paper we
(1) examine the co‐evolution of public debt and private credit since 1870;
(2) ask whether one (or both) is a harbinger of financial crises;
(3) look at the effects of private and public debt overhang and their interaction.
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What we find
Total economy debt levels have risen strongly, but mainly through the private sector.
Private credit booms, not public debt booms, are the best predictor of financial crises.
Private debt overhangs are a problem: more credit intensive booms tend to be followed by deeper recessions and slower recoveries.
High levels of public debt do not matter in normal recessions, but play an important role in financial crisis recessions: this is the time when fiscal space matters.
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MAJOR TRENDS IN THE DATA
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Our data
17 countries: Belgium, Canada, Australia, Denmark, Finland, France, Germany, Italy, Japan, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, U.K. and U.S.
Variables: private and public debt, nominal GDP, real GDP per capita, investment/GDP, CA/GDP, CPI inflation, short‐ and long‐term interest rates.
Recession and Crisis Dates: Bry and Boschan (1971) for recessions. Jordà, Schularick, and Taylor (2012) for normal vs. financial recessions and crisis dates.
Coming attractions: disaggregate bank credit data.
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Financial crises return…
Financial Crises
Out of 17
9
Countries experiencing a crisis in a given year
8
7
6
5
“The oasis
of calm”
4
3
2
1
0
1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
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Public debt vs. private credit
Public and Private Debt
Percent
120
As a percent of GDP, 17 country median
Credit to the private sector
100
80
60
40
Public debt
20
0
1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
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Sharp increase in total debt driven by private sector
Note: median of 17 industrial countries; private debt: total bank lending
to the non-financial private sector.
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DEBT AND FINANCIAL CRISES
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The question
Is private or public borrowing the greater risk to financial stability?
Standard logit financial crisis prediction with country fixed effects:
5‐yr moving averages: parsimonious summary of medium‐term fluctuations and interactions.
Binary classification and predictive ability tests
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Private credit predicts financial crises
Predict financial crises with:
(1)
(2)
(3)
(4)
(5)
Change in private credit

‐

‐
Change in public debt
‐



‐

Level of credit/GDP
‐
‐
‐

‐
Level of debt/GDP
‐
‐
‐
‐
Both interacted
‐
‐
‐



0.61
0.56
0.62
0.61
0.56
Area under the curve (AUC)
 Public debt doesn’t predict, private credit does
(= statistically significant in the logit)
 But let’s not kid ourselves, financial crises are difficult
to predict
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Crisis prediction
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How good is the model?
Predictive Ability Testing: ROC Curve
1
ideal (perfect)
classifier
ROC
0.9
0.8
(FP(c),TP(c))
0.7
0.6
TP = Sensitivity 0.5
0.4
null (uninformative)
classifier
0.3
0.2
0.1
0
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
FP = 1–Specificity
area under curve = AUC
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Private credit wins the horserace
0.00
0.25
Sensitivity
0.50
0.75
1.00
Predictive Ability
0.00
0.25
0.50
1-Specificity
m0 ROC area: 0.5858
mdebt ROC area: 0.6013
Reference
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0.75
1.00
mloans ROC area: 0.6741
mboth ROC area: 0.6778
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Post 1950
0.00
Sensitivity
0.25
0.50
0.75
1.00
Predictive Ability
0.00
0.25
0.50
1-Specificity
m0 ROC area: 0.6201
mdebt ROC area: 0.6267
Reference
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0.75
1.00
mloans ROC area: 0.7196
mboth ROC area: 0.7236
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PRIVATE AND PUBLIC DEBT OVER THE BUSINESS CYCLE: 1870‐2011
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Business cycle chronology
Total = 269; N = 192; F = 77 (all, including wartime periods)
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Business cycle chronology
Total = 269; N = 192; F = 77 (all, including wartime periods)
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Private and public debt over the cycle
Private debt growth is strongly pro‐cyclical
Public debt growth is (somewhat) countercyclical
 Bretton-Woods era stands out as the only period of public debt reduction
in expansions and recessions
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Not all cycles are created equal
 Private credit grows 2x as fast in expansions that end
in financial crisis. Consistent with crisis prediction story.
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DEBT BOOMS AND OVERHANGS: PUBLIC AND PRIVATE
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Debt hangovers
On the private side, deleveraging after credit booms may weigh on aggregate demand Koo (2008); Mian and Sufi (2012), Krugman and Eggertsson (2012): balance sheet repair after asset price collapse or tightening of borrowing limits
On the public side, high levels of public debt may slow down growth
Reinhart et al. (2012) studied 26 episodes where public debt to GDP>90% and found that these episodes were associated with growth slowdown
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Empirical challenge
Can we disentangle these issues based on our near universe of modern business cycle data?
We think so:
First, examine how the overhang of a private credit boom affects the recovery path of the economy.
Second, study the overhang effects of high levels of public debt.
Third, look at the combination of the two.
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The basic set‐up
Consider an economy coming out of a business cycle expansion and entering a recession
Private credit grew 2 s.d. above the country‐
specific historical average in the expansion
Does this change the expected path of the economy through recession and recovery?
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Fed projections for US: could we have known?
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Local projections
What is the effect on the expected future path of the economy, conditional on a rich set of covariates, if private/public debt over the previous expansion deviate from their mean?
Set‐up similar to average treatment effect in dynamic setting if  exogenously determined
Under linearity, this can be approximated through local projections estimating a fixed effects panel (Jordà, AER 2005)
Response hperiods ahead
Dummies for normal
and financial recessions
Deviation of debt
growth from mean in
normal episodes
Deviation of debt
growth from mean in
financial crisis episodes
set of
controls
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PRIVATE DEBT OVERHANG
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Private credit overhang: “credit bites back”
Full sample: 1870–2011
Postwar: 1946–2011
Note: Dotted lines show the effects of a +2 s.d. acceleration in the annual
change of private credit/GDP during the previous expansion. Blue lines
for normal, red lines for financial crisis recessions.
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US vs UK recovery (± shadow banking)
USA real GDP per capita
Cumulative change since the start of the 2007
recession
Percentage
points
15
UK real GDP per capita
Cumulative change since the start of the 2007
recession
Percentage
points
15
10
10
Normal
Normal
5
5
0
0
Actual
Predicted
-5
-5
Actual
Predicted
-10
0
1
2
3
4
-10
0
1
Years
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Years
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PUBLIC DEBT OVERHANG
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Next step: public debt overhang
Reinhart, Reinhart, and Rogoff (2012): high public debt level associated with lower growth
We can easily adapt our conditional analysis to study this effect too
How does the expected path of the economy change if level of government debt g deviates from the mean (0x, 1x, 2x)?
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Crisis recessions worse with public debt overhang
Normal recession
Financial crisis recession
Solid line with 95% confidence region refers to debt at the historical mean (50%) and hence
replicates the average response reported in earlier figures. The dotted line corresponds to
debt at zero and dashed line to debt at twice the mean.
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INTERACTION
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Public credit AND private debt overhang
The third and last step – let’s combine things:
Consider how responses are modulated by the level of public debt at the start of the recession
AND condition on the annual change in private credit during in the prior expansion
Complicated interaction structure, but can be estimated in same way with fixed effects panel
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Fiscal space important — after private credit booms
Normal recession
Financial crisis recession
Both charts display solid lines with normal or financial recession baseline with all variables at
their mean. Other experiments are where private credit grows at the average + 1 s.d. in the
previous expansion. The effect of the private credit overhang is modulated by the level of
public debt to GDP at the start of the recession: dotted line when debt is at zero, a shortdashed line when debt is at the mean, and a long-dashed line when debt is at twice the mean.
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Main conclusions
(1) In advanced economies, financial stability risks typically originate in the private sector. To understand the driving forces of financial crises, one has to study private borrowing and its problems.
(2) Private credit booms adversely affect the post‐
recession path of output and private credit overhang is a regular phenomenon of the modern business cycle.
(3) High levels of public debt can matter for the path of economies out of recessions, confirming the results of Reinhart et al. Yet significant negative effects of high public debt arise only after financial crises and seem to make little difference in normal times.
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