Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty

58 Pages Posted: 10 Aug 2013

See all articles by Russell Cooper

Russell Cooper

University of Texas at Austin - Department of Economics; National Bureau of Economic Research (NBER)

Kalin Nikolov

European Central Bank (ECB)

Date Written: August 2013

Abstract

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 ‘diabolic loop’, is driven by government choice to bail out banks and the resulting incentives for banks to hold government debt rather than to self-insure through equity buffers. We provide conditions such that the ‘diabolic loop’ is a Nash Equilibrium of the interaction between banks and the government. Instability originates in debt markets and is channeled to financial arrangements, and then back again. The analysis highlights the critical role of bank equity for the existence of a diabolic loop. When equity is issued, no diabolic loop exists. In equilibrium, banks' rational expectations of a bailout ensure that no equity is issued and the sovereign-bank loop operates.

Suggested Citation

Cooper, Russell W. and Nikolov, Kalin, Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty (August 2013). NBER Working Paper No. w19278. Available at SSRN: https://ssrn.com/abstract=2308247

Russell W. Cooper (Contact Author)

University of Texas at Austin - Department of Economics ( email )

Austin, TX 78712
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Kalin Nikolov

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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