Summary of the context and overall objectives of the project

In 2007-08, Europe and US were overwhelmed by a financial crisis, followed by a severe, persistent economic recession. Prior to the crisis, there was a debt and asset-price boom. Historical studies show that this is the common pattern:

(i) Financial crises are followed by a strong contraction of aggregate output and employment (and credit) and take a longer time to recover (than non-financial recessions);

(ii) The best predictor of financial crises is an ex-ante strong credit boom (accompanied by high asset prices).

There is growing finance-macro theory and new policy, but no micro evidence. In this project we study: Why are the effects of debt and financial shocks strong and persistent? What are the channels of transmission (households, banks, firms, sovereigns)? As crises are not exogenous, what are the determinants? Can public policy (macroprudential, monetary) alleviate the negative effects? Are there costs or limitations of these policies?

To study these issues, we are constructing several micro datasets that are absolutely new in the literature.

The overall objective is to understand better financial crises and debt shocks, and how to reduce their negative impact on society through very different channels and public policies, including macroprudential and monetary policies.

Main results achieved so far

We show both the positive and negative aspects of some key public policies, and how to increase welfare in crisis times and prevent the likelihood of financial crises, e.g.:
I. Policies such as direct lending from the state can substantially alleviate negative real effects during crisis times, but also show how it can be set up more optimally this public lending.
II. Macroprudential policies, especially targeted on borrowers, can be more effective in reducing the likelihood of financial crises, while macroprudential policies targeted on banks can alleviate the crunches, after crises start.
III. The financial system circumvents some tightening of policies, the so-called regulatory arbitrage, both in European stress testing or the US rise of shadow banks, and therefore it reduces the effects on the economy (not reducing enough the excessive risk-taking in the financial system that creates financial crises.
IV. Financial crises have long-term effects by different channels, for example by reducing the supply of credit to real economy, but also by other non-economic channels like political radicalization. Therefore, public policies via macroprudential and monetary policies but also subsidized lending are crucial to mitigate the effects.
V. Financial shocks (caused by too much debt and leverage) are transmitted internationally but also there are international spillovers of US and Western Europe monetary policies to emerging markets and also to Eastern and Central Europe.
VI. Some positive policies for credit such as expansive monetary policy can increase income, wealth and consumption inequality, despite that they may be crucial to fight periods of low economic activity and inflation. Inequality effects stem from softer monetary policy via debt on housing value, savings, wealth, consumption. Labor income does not compensate these effects.

Overview of the results
• Several top academic publications in finance, management and economics, and various working papers to be revised and resubmit in top-field journals.
• These works present novel methodologies, e.g. on how to analyze macroprudential policies and real effects, how to estimate firm-level effects of bank credit supply effects, on how to analyze household inequality for wealth (housing, stocks, debt, savings) or income (labor income).

Progress beyond the state of the art and expected potential impact

We provide specific answers and tools to understand the determinants and consequences of financial crises (in particular debt), and how public policy (e.g. prudential or monetary policy) can reduce the likelihood of crises, and conditioning on crises, the negative effects.