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

Author

Listed:
  • André Diniz

    (Sao Paulo School of Economics - FGV)

  • Bernardo Guimaraes

    (Sao Paulo School of Economics - FGV
    Centre for Macroeconomics (CFM))

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.

Suggested Citation

  • André Diniz & Bernardo Guimaraes, 2017. "How diabolic is the sovereign-bank loop? The effects of post-default fiscal policies," Discussion Papers 1705, Centre for Macroeconomics (CFM).
  • Handle: RePEc:cfm:wpaper:1705
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    More about this item

    Keywords

    Financial Frictions; Fiscal Policy; Soverign Default; Soverign-bank Loop;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G01 - Financial Economics - - General - - - Financial Crises
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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