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

Published online by Cambridge University Press:  11 November 2021

André Diniz  and
Bernardo Guimaraes
André Diniz
Affiliation:
Kinea, Economics Department, São Paulo, Brazil
Bernardo Guimaraes*
Affiliation:
Sao Paulo School of Economics – FGV Fundação Getúlio Vargas, Rua Itapeva 474, 01332-000 São Paulo, Brazil
*
*Corresponding author: Bernardo Guimaraes. Email: bernardo.guimaraes@fgv.br
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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.

Keywords

Financial frictionsfiscal policysovereign defaultsovereign-bank loopE32E62F34G01H63
Type
Articles
Information
Macroeconomic Dynamics , Volume 27 , Issue 3 , April 2023 , pp. 601 - 634
Copyright
© The Author(s), 2021. Published by Cambridge University Press

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