Fiscal buffers, private debt, and recession: The good, the bad and the ugly

Focusing on Euro Area countries we show empirically that higher private debt leads deeper recessions, while higher public debt does not, unless the level of public debt is especially high. We then build a general equilibrium model that replicates these dynamics, and use it to design a policy that can mitigate the recessionary consequences of private deleveraging. In the model, following financial shocks, recessions are milder and public debt is more contained when the government lends directly to those households and firms that face binding borrowing constraints. Accordingly, the resulting gains from this policy increase with more bountiful fiscal buffers.