Sovereigns versus banks: Crises, causes and consequences

Òscar Jordà, Moritz Schularick, Alan Taylor, 18 October 2013



Some observers – often with great conviction – see the European crisis through the lens of public finance (Alessandrini et al. 2012). They see the key source of the problem as the inherent inability of past governments (many in the periphery, and possibly soon even some in the core) to live within their means. For these observers, stricter fiscal rules – a ‘better Maastricht’ – are what would have saved the day, and what will now be required to prevent another crisis down the road.

Others argue that we should worry about private borrowing the most. According to this perspective, the crisis in Europe (setting aside the blatantly misleading public accounting in Greece) is the result of credit booms and housing bubbles that emanated from the private sector, and which were fueled by private cross-border lending flows. When the bubbles eventually burst, the public sector was forced to absorb the direct costs of banking losses and/or the much larger indirect costs of extreme cyclical deficits, picking up the pieces as best it could to prevent the economy from going into a tailspin. In other words, the surge in public debt is merely an epiphenomenon.

Yet, to a large degree, the debate over these narratives has proceeded with scant reference to empirical evidence from macroeconomic history.

In new research (Jordà, Schularick, and Taylor 2013) we fill this gap by studying the co-evolution of public- and private-sector debt in 17 advanced countries since 1870. Using new methods combined with a comprehensive set of macroeconomic controls, and a consistent chronology of business cycles and financial crises, we present the first systematic study of the joint dynamics of public and private debt over the modern business cycle.

Key long-run trends

Figure 1 shows the evolution of public debt (general consolidated government debt) and private credit (bank loans to the non-financial sector) in advanced economies since 1870. The figure conveys two key messages. First, although public debt ratios had climbed from the late 1970s until the mid-1990s, they had declined toward their historical peacetime average prior to the global financial crisis of 2008. Second, in a break with historical patterns, private credit maintained a fairly stable relationship with GDP until the 1970s, and then surged to unprecedented levels in the decades that followed and right up to the outbreak of the crisis. The implications of this increasing financialisation in Western economies are profound, and have become an active area of investigation. The takeaway is clear – in looking for the proximate cause of the crisis, prima facie evidence favors private-sector borrowing over public-sector debt.

Figure 1. Private credit and public debt in advanced economies since 1870

Source: Jordà, Schularick, and Taylor (2013). Private credit is aggregate private bank loans to the non-financial sector. Public debt is general consolidated government debt. The average is for 17 advanced economies: Australia, Belgium, Canada, Denmark, Finland, France, Germany, Italy, Japan, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the UK, and the US.

Financial crises: Sovereigns vs banks

Is private or public borrowing the greater risk to financial stability? To move beyond the suggestive evidence in Figure 1, we consider which type of borrowing, private or public, is the better harbinger of financial instability. The standard financial crisis prediction framework used in Schularick and Taylor (2012) provides a good way to do this.

The message from the binary classification analysis in Table 1 reinforces the message from Figure 1. Historically, risks to financial stability have typically originated in the private sector, not in the public sector. This finding is consistent with the events of 2008 – with the exception of dangerous levels of government debt in Greece, most other advanced countries did not have obvious public debt problems ex ante. Ex post, the devastation from the financial crisis recession would wreak havoc on public finances via crashing revenues and rising cyclical expenditures.

Table 1. Financial crisis predictive ability: Private credit growth vs. public debt growth

Notes: Robust standard errors in parentheses. *** p<0.01, ** p<0.05, * p<0.1. Country fixed e↵ects in all models, not reported. The null model with fixed effects only has AUC = 0.533 (0.03). Interaction term = (Lagged level of private credit/GDP) × (Lagged level of public debt/GDP).
Source: Jordà, Schularick, and Taylor (2013).

Varieties of debt overhang: Public vs private

Does excessive past debt accumulation cast a shadow over the economy? Since the crisis, two different warnings about the effects of debt overhang have emerged. The first warning is that elevated levels of private indebtedness may hold back economic recovery. Investors suddenly realise that asset values were too high and leverage limits too lax. After this ‘Minsky moment’, households (or companies) adjust their debt levels, repair their balance sheets, and retrench. This deleveraging process in turn weighs on aggregate demand and can explain the sluggish recovery (Koo 2008; Mian and Sufi 2012; Mian, Rao, and Sufi 2013; Jordà, Schularick, and Taylor forthcoming).

The second warning is on the effects of the overhang from public, not private, borrowing. Reinhart et al. (2012) studied 26 episodes where public debt accounted for more than 90% of GDP on a sustained basis, and found evidence that these episodes were associated with a substantial slowdown of GDP growth relative to low-debt years. These results mesh with those of a much-debated earlier contribution by Reinhart and Rogoff (2009) that presented evidence that above a certain public-debt-to-GDP threshold, the overhang of public debt goes hand in hand with a substantial slowdown in economic growth.

A new empirical approach

Which of these two warnings should be heeded? An answer that moves beyond an unconditional analysis of the data, and the focus on one kind of leverage at a time, requires new statistical solutions. Our approach is to include a broad panel of macroeconomic controls in a dynamic setting to isolate the marginal contribution of both private and public borrowing to the pace of recovery.

With each layer of analysis, the answer becomes more unequivocal. High levels of public debt have little impact on business cycle dynamics in normal times. However, a public debt overhang can be potentially problematic after leverage-driven financial crises.

Figure 2 shows that inheriting high levels of public debt can lead to an enormous drag on the recovery, especially when this coincides with a sizeable private credit overhang. The figure displays the typical path of a normal recession juxtaposed against the paths in a financial crisis when private credit in the expansion grows one standard deviation above average combined with low (indicated by the dotted line), medium (dashed line) and high (long dashed line) levels of debt-to-GDP at the start of the recession. When a private-sector credit boom is unwound, high levels (about 100% of GDP) of public debt turn out to be very problematic. Output remains severely depressed for many years, being far off the previous peak even in year five.

High levels of public debt can be dangerous, and our findings argue in support of the idea of keeping public debt low for precautionary reasons. In particular, should a financial crisis recession strike, high initial levels of public debt are associated with prolonged spells of weak growth, potentially for a number of reasons:

  • High debt might undercut the government’s ability to use fiscal policy to counteract the drag from private-sector balance sheet repair;
  • High sovereign risk may undermine the value of the private banking system’s assets, i.e. the ‘doom loop’; and
  • The government may be unable to fulfill its lender of last resort function.

Figure 2. High public debts plus private credit booms coincide with harsher recessions after financial crises

Note: Cumulative response of output in a normal (blue) and financial crisis (red) recession. The solid lines depict the average response in each type of recession with all variables at their mean, and in the normal case with a 95% confidence region. The various non-solid lines indicate how the path of the economy differs with two simultaneous perturbations: when private credit grows at the average level plus one standard deviation in the previous expansion; and, in addition, when public debt is set at zero, at 51% of GDP (the mean), or at twice the mean (slightly above 100% of GDP). Each of these debt levels is represented with a dotted line when debt is at zero, a short-dashed line when debt is at the mean, and a long-dashed line when debt is at twice the mean.
Source: Jordà, Schularick, and Taylor (2013).


The long-run historical record underscores the central role played by private-sector borrowing behavior for the buildup of financial instability.

  • The idea that financial crises typically have their roots in fiscal problems is not supported by history.
  • We find evidence, however, that high levels of public debt can matter for the path of the recovery, confirming the results of Reinhart et al. (2012).

However, this effect is related to recoveries from financial crises rather than typical recessions.

  • While high levels of public debt make little difference in normal times, entering a financial crisis recession with an elevated level of public debt exacerbates the effects of private-sector deleveraging, and typically leads to a prolonged period of sub-par economic performance.

Put differently, the long-run data suggest that without enough fiscal space, a country’s capacity to perform macroeconomic stabilisation and resume growth may be impaired.


Alessandrini, Pietro, Andrew Hughes Hallett, Andrea F Presbitero, and Michele Fratianni (2012), “The Eurozone crisis: Fiscal fragility, external imbalances, or both?”,, 16 May.

Koo, Richard (2008), The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, New York: Wiley.

Jordà, Òscar, Moritz Schularick, and Alan M Taylor (Forthcoming), “When Credit Bites Back”, Journal of Money, Credit and Banking. Previously published as CEPR Discussion Paper 8678.

Jordà, Òscar, Moritz Schularick, and Alan M Taylor (2013), “Sovereigns versus Banks: Crises, Causes and Consequences”, CEPR Discussion Paper 9678.

Mian, Atif, Kamalesh Rao, and Amir Sufi (2013), “Household Balance Sheets, Consumption, and the Economic Slump”, Chicago Booth Research Paper 13-2.

Mian, Atif, and Amir Sufi (2012), “What Explains High Unemployment? The Aggregate Demand Channel”, NBER Working Paper 17830.

Reinhart, Carmen M, Vincent Reinhart, and Kenneth S Rogoff (2012), “Debt Overhangs: Past and Present”, NBER Working Paper 18015.

Reinhart, Carmen M and Kenneth S Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton, NJ: Princeton University Press.

Schularick, Moritz, and Alan M Taylor (2012), “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870–2008”, The American Economic Review 102(2): 1029–61.

Topics: Economic history, Financial markets, Macroeconomic policy
Tags: business cycles, debt, financial crises, fiscal space

Research Advisor, Federal Reserve Bank of San Francisco; Professor of Economics, UC Davis

Professor of Economics at the University of Bonn

Professor of Economics and Finance, University of California, Davis; Research Fellow, CEPR