How a private credit boom can lead to a sovereign debt crises | FRBSF

From a FRBSF paper Private Credit and Public Debt in Financial Crises by Òscar Jordà, Moritz Schularick, and Alan M. Taylor:

Recovery from a recession triggered by a financial crisis is greatly influenced by the government’s fiscal position. A financial crisis puts considerable stress on the government’s budget, sometimes triggering attacks on public debt. Historical analysis shows that a private credit boom raises the odds of a financial crisis. Entering such a crisis with a swollen public debt may limit the government’s ability to respond and can result in a considerably slower recovery.

In financial crises, steep declines in output worsen the ratio of public debt to gross domestic product (GDP) even if the nominal amount of debt remains unchanged. Progressive tax systems cause government revenues to decline at a faster rate than output. Meanwhile, other automatic stabilizers, such as unemployment insurance programs, quickly swell public expenditures. The public sector often assumes private-sector debts to prevent a domino effect of defaults from toppling the financial system. Programs to stimulate the economy put further stress on public finances. As budget deficits balloon, deep economic downturns resulting from a private credit crunch often turn into sovereign debt crises.

Read more at Federal Reserve Bank San Francisco | Private Credit and Public Debt in Financial Crises.

Hat tip to Barry Ritholz