Government Debt: A Key Role in Financial Intermediation

This paper discusses why policymakers in public finance view debt devaluation wearily; debt devaluation is desirable as it reduces government costs and saves precious tax income. It shows that domestic banks choose to be greatly exposed to government debt because other options, such as private debt, are more risky under regulatory and institutional imperfections. This pattern creates a vulnerability for domestic banks and borrowers due to the exposure to the government's debt policy. Policymakers are therefore hesitant to devalue debt as it has the potential to damage domestic banks and borrowers. The authors argue this need not be an assumption in every instance.