Financial Fragility and the Fiscal Multiplier

We show that undercapitalized banks with large holdings of government bonds subject to sovereign default risk lead to a new crowding-out channel: deficit-financed fiscal stimuli lead to higher bond yields, triggering capital losses for the banks. Banks then cut back loans, which reduces fiscal multipliers. Crowding out increases for longer maturity bonds and higher sovereign default risk. We estimate a dynamic stochastic general equilibrium (DSGE) model with financial frictions for Spain and find strong support for these results. The cumulative multiplier decreases substantially with the size of the stimulus, and with the amount of time between the announcement and implementation of the stimulus.