Financial and fiscal interaction in the Euro Area crisis: This time was different

Caruso, A, Reichlin, L and Ricco, G (2019) Financial and fiscal interaction in the Euro Area crisis: This time was different. European Economic Review, 119. pp. 333-355. ISSN 0014-2921

Abstract

This paper highlights the anomalous characteristics of the Euro Area ‘twin crises’ by contrasting the aggregate macroeconomic dynamics in the period 2009–2013 with the business cycle fluctuations of the previous decades. We report three novel stylised facts. First, the contraction in output was marked by an anomalous downfall in private investment and an increase in households’ savings, while consumption and unemployment followed their historical relation with GDP. Second, households’ and financial corporations’ debts, and house prices deviated from their pre-crisis trends, while non-financial corporations’ debt followed historical regularities. Third, the jumps in the public deficit-GDP and debt-GDP ratios in 2008–2009 were unprecedented and so was the fiscal consolidation that followed. Our analysis points to the financial nature of the crisis as a likely explanation for these facts. Importantly, the ‘anomalous’ increase in public debt is in large part explained by extraordinary measures in support of the financial sector, which show up in the stock-flow adjustments and reveal a key interaction between the fiscal and the financial sectors.