Sovereign Debt, Government Myopia, and the Financial Sector

52 Pages Posted: 15 Dec 2011 Last revised: 10 Sep 2013

Viral V. Acharya

New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Raghuram G. Rajan

University of Chicago - Booth School of Business; International Monetary Fund (IMF); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: December 2011

Abstract

What determines the sustainability of sovereign debt? In this paper, we develop a model where myopic governments seek electoral popularity but can nevertheless commit credibly to service external debt. They do not default when they are poor because they would lose access to debt markets and be forced to reduce spending; they do not default when they become rich because of the adverse consequences to the domestic financial sector. Interestingly, the more myopic a government, the greater the advantage it sees in borrowing, and therefore the less likely it will be to default (in contrast to models where sovereigns repay because they are concerned about their long term reputation). More myopic governments are also likely to tax in a more distortionary way, and create more dependencies between the domestic financial sector and government debt that raise the costs of default. We use the model to explain recent experiences in sovereign debt markets.

Suggested Citation

Acharya, Viral V. and Rajan, Raghuram G., Sovereign Debt, Government Myopia, and the Financial Sector (December 2011). NYU Working Paper No. 2451/31365. Available at SSRN: https://ssrn.com/abstract=1972803

Viral V. Acharya (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

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Centre for Economic Policy Research (CEPR)

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New York University (NYU) - Department of Finance

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Raghuram G. Rajan

University of Chicago - Booth School of Business ( email )

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International Monetary Fund (IMF) ( email )

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National Bureau of Economic Research (NBER)

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