Sovereign Debt and Political Economy

Why do sovereign countries pay their debt? How do political-economy constraints affect international financial markets? Why do countries default and when should they? These are among the most basic and important questions in International Finance, affecting policy makers, international financial institutions, supra-national institutions and entire countries. However, economists do not have convincing answers to any of these questions, and hence important issues like the welfare effects of reforms to the international financial system cannot be analyzed. The current project develops and tests a tractable model of sovereign debt repayment that provides answers to several of these questions. The model generates a novel set of empirical predictions, and it can be used for welfare analysis.

The first part of the project shows that the same economic forces that generate overspending in a political-economy model, can guarantee that a small open economy repays its sovereign obligations, even in the absence of direct sanctions. This model endogenously generates a non-trivial borrowing limit and ties the debt capacity of a country to several empirically relevant variables, such as the size of the shocks faced by the domestic economy, the number of political parties or regions, the discount rate of the domestic agents, and the international interest rate. The model provides several novel empirical predictions relating to the political system, domestic institutions and the amount of borrowing in an economy.

The project generates an explicit model of savings by a group of agents that interact repeatedly. Hence, the applicability of the basic model extends beyond the particular case in focus: that of countries participating in the international financial market. For example, the model could be useful in explaining household savings behavior, public good provisions, and resource extraction problems, thereby giving it broader impacts.

Once the model has been solved, comparative-static results can be generated and the implied empirical predictions tested. Finally, the model can be used to study the welfare effects of changes in the international financial system and in certain domestic institutions that are relevant for access to that system.

This project aims to answer the questions of what keeps countries from defaulting on their external obligations. The modern quantitative literature has so far by-passed this question and assumed the existence of an exogenous cost of defaulting. However, the nature of this exogenous cost has been difficult to identify and quantify empirically. By introducing political economy considerations into a fairly standard model, this project develops a rich set up where debt is repaid in equilibrium and where the particular form of punishment after default is the one that has been prevalent among all defaults: countries when defaulting are excluded from borrowing again.