Financial Intermediation and Government Debt Default

Recent empirical evidence suggests that the major cost of sovereign default lies in its effects on the domestic financial system, rather than any external sanctions. To explore this link, we extend the banking model of Gertler and Karadi (2011) to allow banks to hold risky long-term government debt, and then incorporate bank runs following Gertler and Kiyotaki (2013). Banks face an agency problem that limits their ability to issue loans. The government may default on its debt, and the default probability depends on a fiscal limit that measures the government’s ability to payoff its debt. In this way we can analyse the interactions between banking and sovereign debt crises. By allowing for distortionary taxes, sticky prices and a debt maturity structure, we also have a rich model of monetary and fiscal policy interactions and can explore how these policies influence developments in the financial and fiscal spheres. We find that without bank runs, sovereign default can reduce investment by a substantial margin and keep capital at a low level for a prolonged period of time; sovereign default risk by itself, however, has a small impact on the economy. On the other hand, if bank runs are possible, sovereign default risk, even if a default does not materialise, is stagflationary and has dramatic and negative impact on the economy.