Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty
NBER Working Paper No. 19278
This paper studies the interaction of government debt and financial markets. Both markets are fragile: excessively responsive to fundamentals and prone to strategic uncertainty. This interaction, termed a ʽdiabolic loopʼ, is driven by government willingness to bail out banks and the resulting incentives for banks not to self-insure through equity buffers. We provide conditions such that the ʽdiabolic loopʼ is a Nash Equilibrium of the interaction between banks and the government arising from instability in debt markets and financial arrangements.
This paper was revised on July 27, 2015
Document Object Identifier (DOI): 10.3386/w19278
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