This paper studies the effects of fiscal policy response in 118 episodes of the systemic banking crisis in advanced and emerging market countries during 1980–2008. It finds that timely countercyclical fiscal measures contribute to shortening the length of crisis episodes by stimulating aggregate demand. Fiscal expansions that rely mostly on measures to support government consumption are more effective in shortening the crisis duration than those based on public investment or income tax cuts. But these results do not hold for countries with limited fiscal space where fiscal expansions are prevented by funding constraints. The composition of countercyclical fiscal responses matters as well for output recovery after the crisis, with public investment yielding the strongest impact on growth. These results suggest a potential trade-off between short-run aggregate demand support and medium-term productivity growth objectives in fiscal stimulus packages adopted in distress times.

The financial crisis that started in the mortgage sector of the United States in 2007 turned into a worldwide credit crunch and subsequently triggered a global recession in 2009. With access to credit markets hampered by financial distress, private consumption falling owing to income and wealth effects, and new investment constrained by the negative economic prospects, governments implemented numerous measures to restore growth and regain market confidence (IMF, 2009a). Governments’ policy reactions have focused on fixing the banking system to help reestablish the flow of credit to the economy and implementing fiscal and monetary stimulus packages to sustain aggregate demand and prevent a downward spiral of output (IMF, 2009d). As room for monetary easing rapidly shrank, reflecting limited space for additional interest rate cuts and impaired monetary policy transmission channels, fiscal policy became the principal tool for stimulating economic recovery (Christiano, Eichenbaum, and Rebelo, 2009). To what extent fiscal policy will be effective in supporting growth recovery both in the short term and over time is subject of much debate (Jansen et al., 2008).