Deadly Embrace: Sovereign and Financial Balance Sheets Doom Loops

Emmanuel Farhi, Jean Tirole

NBER Working Paper No. 21843
Issued in January 2016
NBER Program(s):   EFG   IFM   ME   PE

The recent unravelling of the Eurozone’s financial integration raised concerns about feedback loops between sovereign and banking insolvency, and provided an impetus for the European banking union. This paper provides a “double-decker bailout” theory of the feedback loop that allows for both domestic bailouts of the banking system by the domestic government and sovereign debt forgiveness by international creditors or solidarity by other countries. Our theory has important implications for the re-nationalization of sovereign debt, macroprudential regulation, and the rationale for banking unions.