Debt and Depth of Recessions

Donghyun Park,Kwanho Shin,Shu Tian

doi:10.22617/wps190126-2

Abstract

This paper empirically investigates the relationship between the speed of buildup of private debt (household and corporate) and the depth of recessions. To do this, we differentiate between financial recessions and normal recessions on the basis of how quickly their private debt builds up. In addition to output recessions, we look at consumption and investment recessions. We find that financial recessions are deeper than normal recessions in advanced economies—and the differences become even more pronounced when emerging market economies are added to the sample. Our evidence suggests that a buildup in corporate debt is especially damaging for emerging markets during financial recessions. A higher ratio of debt to gross domestic product—in other words, less fiscal space—exacerbates recessions only beyond a certain threshold level, suggesting a nonlinear effect. We find that the buildup of corporate debt—and not just household debt—can worsen recessions, especially in emerging market economies.

Highlights

The Great Recession triggered by the global financial crisis (GFC) underlines the danger of recessions driven by financial crises
When we further distinguish between financial recessions that are driven by household rather than corporate debt buildups, we find that recessions driven by household debt buildups are generally deeper than those driven by corporate debt buildups in advanced economies (AEs), a finding in line with the literature
This paper empirically investigates the relationship between the buildup of private debt, which consists of household debt and corporate debt, and the depth of recessions

Summary

Introduction

The Great Recession triggered by the global financial crisis (GFC) underlines the danger of recessions driven by financial crises. Some of the countries hit by the GFC have yet to fully recover. The severity of recessions that coincided with booms and busts of financial cycles led to studies examining whether recessions associated with financial busts tend to be deeper than other recessions. Kose, and Terrones (2012) find strong links between business and financial cycles, as well as the pronounced severity and persistence of recessions accompanying busts in house and equity prices. Schularick, and Taylor (2013) find that recessions caused by financial crises are costlier than normal recessions, and that credit-intensive expansions tend to be followed by deeper recessions. Romer and Romer (2017a) find that the decline in output following a financial crisis is significant and persistent

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Conclusion