Political Economics of External Sovereign Defaults
72 Pages Posted: 17 Jul 2015
Date Written: July 2, 2015
We develop a dynamic recursive model where political and economic decisions interact, to study how excessive debt-GDP ratios affect political sustainability of prudent fiscal policies. Rent seeking groups make political decisions – to cooperate (or not) – on the allocation of fiscal budgets (including rents) and issuance of sovereign debt. A classic commons problem triggers collective fiscal impatience and excessive debt issuing, leading to a vicious circle of high borrowing costs and sovereign default. We analytically characterize debt-GDP thresholds that foster cooperation among rent seeking groups and avoid default. Our analysis and application helps in understanding the politico-economic sustainability of sovereign rescues, emphasizing the need for fiscal targets and possible debt haircuts. We provide a calibrated example that quantifies the threshold debt-GDP ratio at 137%, remarkably close to the target set for private sector involvement in the case of Greece.
Keywords: sovereign debt, rent seeking, world interest rates, international lending, incentive compatibility, tragedy of the commons, EU crisis, Grexit, Graccident
JEL Classification: H63, F34, F36, G01, E44, E43, D72
Suggested Citation: Suggested Citation