Fiscal Buffers, Private Debt and Recession: The Good, the Bad and the Ugly

Abstract

Focusing on Euro-Area countries, we show empirically that higher private debt leads to deeper recessions while higher public debt does not, unless its level is especially high. We then build a general equilibrium model that replicates these dynamics and use it to design a policy that can mitigate the recessionary consequences of private deleveraging. In the model, in the aftermath of financial shocks, recessions are milder and public debt is more contained when the government lends directly to those households and firms that face binding borrowing constraints. As a consequence, large fiscal buffers are critical to enhance macroeconomic resilience to financial shocks.

Keywords: private debt, public debt, financial crisis, financial shocks, borrowing constraints, fiscal limits

JEL Classification: E44, E62, H63