Fiscal Space and Policy Response to Financial Crises: Market Access and Deficit Concerns

Abstract

Existing literature suggests that fiscal space matters for the policy response to financial crises. High public debt levels limit countries capacity to pursue macroeconomic and financial stabilization policies and resume growth after severe crisis downturns. We examine the involved channels through which fiscal space matters for the dynamics of fiscal policy after a financial distress, namely sovereign market access and policymakers’ views, in a panel of 30 OECD countries for the period 1980–2017. We introduce a non-linear measure of fiscal space, which further considers simultaneously both the debt-to-GDP ratio capturing long-term features of countries’ policy-making processes and budgetary balances that capture recent policy decisions and persistent fiscal deficits. We document a substantially strengthened role for sovereign market access constraints in driving the policy response to distress once fiscal space non-linearity is introduced in the model, which highlights the non-linearity involved in market participants’ concerns about fiscal space. Moreover, the vulnerability of market access concerning fiscal space is affected by either the debt-to-GDP ratio or fiscal balances dominating the assessment of fiscal space. The role of fiscal health and the policymakers’ views channel is more pronounced once flows of budget deficits are at the epicenter of the assessment of fiscal space, suggesting a “deficit concerns” channel.