How diabolic is the sovereign-bank loop? The effects of post-default fiscal policies

André Diniz and Bernardo Guimaraes

Macroeconomic Dynamics, 2023, vol. 27, issue 3, 601-634

Abstract: The deleterious effect of debt restructuring on banks’ balance sheets and, consequently, on the economy as a whole has been a key policy issue. This paper studies how post-default fiscal policy interacts with this sovereign-bank loop and shape the response of a model economy. Calibration of the model matches characteristics of the Greek economy at the time of the bond exchange. Debt restructuring in place of higher lump-sum taxation or lower nonproductive government spending harms the economy even if no other cost of default is considered. However, the sovereign-debt loop is less costly to the economy than increases in labor or capital taxes to service debt. Even so, if fiscal policy is too responsive, a crowding-out effect inhibits the recovery of capital markets, hence a more conservative fiscal stance is desirable. Thus, how diabolic the post-default sovereign-bank loop is depends to a large extent on the way fiscal policy responds.

Date: 2023
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Working Paper: How diabolic is the sovereign-bank loop? The effects of post-default fiscal policies (2017)
Working Paper: How diabolic is the sovereign-bank loop? The effects of post-default fiscal policies (2017)
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