Seminar: Financial Fragility and the Fiscal Multiplier

Time: 13.00-14.00 hours
Location: CPB-office, Van Stolkweg 14, The Hague

Presentation: Sweder van Wijnbergen (UvA)

Discussant: Adam Elbourne (CPB)

Language: English

Registration:  Please register by sending an email to seminars@cpb.nl.

Abstract subject
We investigate the effectiveness of `Keynesian' fiscal stimuli when government deficits and debt rollovers are financed by balance sheet constrained financial intermediaries. Because financial intermediaries operate under a leverage constraint, deficit financing of fiscal stimulus packages will cause interest rates to rise as private loans are crowded out by government debt in the credit provision channel. This lowers investment and (future) capital stocks, which affect output negatively for a prolonged period. Anticipations of these future consequences cause the price of capital to drop immediately when the policy is announced, inflicting capital losses on banks which leads to further tightening of leverage constraints and credit market conditions, thereby triggering a negative amplification cycle further lowering the fiscal multiplier. Moreover, current and anticipated future new debt issues associated with a Keynesian stimulus package cause prices of long term bonds to fall. Financial intermediaries then incur additional losses, with associated further tightening of leverage and credit constraints, and more negative output effects. When in addition sovereign default risk is introduced, additional capital losses may occur and outcomes deteriorate further after a deficit financed stimulus package, eventually implying a Keynesian multiplier close to zero or even negative. Of course we do not argue that multipliers are always negative; but financial fragility and sovereign risk problems may severely lower them, possibly to the point of becoming negative.

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