NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty

Russell Cooper, Kalin Nikolov

NBER Working Paper No. 19278
Issued in August 2013
NBER Program(s):   EFG

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.

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This paper was revised on July 27, 2015

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Document Object Identifier (DOI): 10.3386/w19278

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