The literature on costs of financial instability tends to focus on fiscal costs and the impact on GDP of banking crises. In this paper we analyse the effect of a banking or currency crisis on consumption. We show that consumption plays an important role in the macroeconomic adjustment following a financial crisis. Furthermore, the effect of a crisis is aggravated by high leverage, notably as shown by the effect of a high debt-income ratio, despite the benefits of financial liberalisation in easing liquidity constraints. It is also greater in a small open economy than in the G-7. Meanwhile, falling house prices are shown to be part of the transmission process of financial instability, and high nominal interest rates are an indicator of sharp declines in consumption. A simulation for a banking crisis underlines the important role of monetary and fiscal policy in easing the impact of a financial crisis on consumption and other expenditure components. Viewed in the light of growing gearing, or leverage, in recent years, the results imply that a banking crisis taking place now could have a greater incidence than in the past, especially if macroeconomic policy is unable to respond, as for a small country in EMU.
<a href="/PRESS/PRDP243.pdf">View Press release: Banking Crises and Consumption (74kb), Tuesday 20th July 2004</a>