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

Andre Diniz and Bernardo Guimaraes

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

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 non-productive 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 labour 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

Keywords: financial frictions; fiscal policy; sovereign default; sovereign-bank loop. (search for similar items in EconPapers)
JEL-codes: E32 E62 F34 H63 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-eec and nep-mac
Date: 2017-01
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