Capital Flow Freezes

Abstract

The period following the 2008 financial crisis focused attention on "twin-crises," where banking crises precipitate sovereign crises due to increased bank support. We show that when private sector debt is renegotiated centrally, and bargaining power is low, it results in suboptimally low levels of debt and default rates (haircuts). If, instead, the bargaining power is sufficiently high, the supply of debt exceeds its demand and capital inflows "freeze". These inefficiencies arise because the decentralized borrowers fail to consider how their bond supply impacts debt renegotiation outcomes, affecting both bond prices and the asset span. These issues can be addressed through macroprudential policies in the form of taxing capital inflows.

Publisher

Springer

Publication Date

9-24-2024

Publication Title

Economic Theory

Department

Economics

Document Type

Article

DOI

https://doi.org/10.1007/s00199-024-01604-6

Keywords

Open economy, Capital flows, Capital flow freezes, Debt, Default, Renegotiation, F34, G15, G18

Language

English

Format

text

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