Long Term Government Debt, Financial Fragility and Sovereign Default Risk

Tinbergen Institute Discussion Paper 13-052/VI/DSF55

31 Pages Posted: 3 Apr 2013 Last revised: 4 Apr 2013

See all articles by Christiaan van der Kwaak

Christiaan van der Kwaak

University of Amsterdam

Sweder van Wijnbergen

Universiteit van Amsterdam; Tinbergen Institute; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: March 31, 2013

Abstract

We analyze the interaction between bank rescues, financial fragility and sovereign debt discounts. We construct a model that contains balance sheet constrained financial intermediaries financing both capital expenditure of intermediate goods producers and government deficits. The financial intermediaries face the risk of a (partial) default of the government on its debt obligations. We analyse the impact of a financial crisis, first under full government credibility and then with an endogenous sovereign debt discount. The introduction of the default possibility does not have any impact if all government debt is short term. Interest rates on debt reflect higher default probabilities, but because all debt is short term, bank balance sheets are unaffected and no further negative effects arise through the endogenous sovereign debt channel. But once long term government debt is introduced, the possibility of capital losses on bank balance sheets arises. Then outcomes significantly deteriorate compared to the short term debt only case. Higher interest rates on new debt lead to capital losses on banks' holding of existing long term government debt. The associated increase in credit tightness leads to a negative amplification effect, significantly increasing output losses and declines in investment after a financial crisis. This causes potentially conflicting macroeconomic effects of a debt financed recapitalization of banks. We investigate the case where the government announces a bank recapitalization to occur 4 quarters after announcement. Under the parameter values chosen, the positive effects from an anticipated capital injection dominate the effects of the associated increase in sovereign default risk.

Keywords: Financial Intermediation, Macrofinancial Fragility, Fiscal Policy, Sovereign Default Risk

JEL Classification: E44, E62, H30

Suggested Citation

van der Kwaak, Christiaan and van Wijnbergen, Sweder, Long Term Government Debt, Financial Fragility and Sovereign Default Risk (March 31, 2013). Tinbergen Institute Discussion Paper 13-052/VI/DSF55. Available at SSRN: https://ssrn.com/abstract=2243547 or http://dx.doi.org/10.2139/ssrn.2243547

Christiaan Van der Kwaak

University of Amsterdam ( email )

Spui 21
Amsterdam, 1018 WB
Netherlands

Sweder Van Wijnbergen (Contact Author)

Universiteit van Amsterdam ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands
+31 20 525 4011 / 4203 (Phone)
+31-35-624 91 82 (Fax)

Tinbergen Institute

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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