Capital flow freezes

M. Udara Peiris (), Anna Sokolova () and Dimitrios P. Tsomocos ()
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M. Udara Peiris: Oberlin College
Anna Sokolova: University of Nevada Reno
Dimitrios P. Tsomocos: University of Oxford

Economic Theory, 2025, vol. 79, issue 3, No 4, 853-887

Abstract: Abstract The period following the 2008 financial crisis focused attention on “twin-crises,” where banking crises precipitate sovereign crises due to increased bank support. We show that when private sector debt is renegotiated centrally, and bargaining power is low, it results in suboptimally low levels of debt and default rates (haircuts). If, instead, the bargaining power is sufficiently high, the supply of debt exceeds its demand and capital inflows “freeze”. These inefficiencies arise because the decentralized borrowers fail to consider how their bond supply impacts debt renegotiation outcomes, affecting both bond prices and the asset span. These issues can be addressed through macroprudential policies in the form of taxing capital inflows.

Keywords: Open economy; Capital flows; Capital flow freezes; Debt; Default; Renegotiation (search for similar items in EconPapers)
JEL-codes: F34 G15 G18 (search for similar items in EconPapers)
Date: 2025
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DOI: 10.1007/s00199-024-01604-6

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