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

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  • Diniz, Andre
  • Guimaraes, Bernardo

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

  • Diniz, Andre & Guimaraes, Bernardo, 2017. "How diabolic is the sovereign-bank loop? The effects of post-default fiscal policies," LSE Research Online Documents on Economics 86169, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:86169
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    File URL: http://eprints.lse.ac.uk/86169/
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    References listed on IDEAS

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    More about this item

    Keywords

    financial frictions; fiscal policy; sovereign default; sovereign-bank loop.;

    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
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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