Government Debt and Banking Fragility: The Spreading of Strategic Uncertainty

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.