The effects of fiscal policy during the financial crises in transition and emerging countries: Does fiscal policy matter?

Abstract

The article investigates empirically the effect of fiscal policy using 101 episodes of banking crisis in transition and emerging countries during the period 1980 to 2013. The research question is whether the timely undertaking of fiscal policy measures would have shortened the length of the financial crisis? Based on data from Leaven and Valencia (2012), we employ OLS with robust standard error and ordered logit model in order to examine the countercyclical effect of fiscal policy during the systematic banking crisis. We find out that countercyclical fiscal policy measures have a positive effect in shortening the length of the financial crisis. The results suggest that fiscal expansion can shorten the length of the financial crisis by nine months in those countries. The countercyclical fiscal measures of income tax cuts are more effective than government consumption in shortening the duration of the crisis. In addition, the results show the effect of income tax cuts become weaker or lose their effect after the output recovery, i.e., after the crisis. Thus, it holds that public investments have the strongest positive effects on economic growth in the medium term and decomposition of fiscal policy matters.