Sovereign Debt and Political Economy
Summary:
The goal of this project is to develop a tractable model of sovereign debt, to investigate the role that political considerations play in the sovereign debt market, to provide a novel explanation for the levels of sovereign borrowing observed in the data, and to test empirical implications generated by the theory.
Intellectual Merit:
The first step in the project is to develop a tractable and realistic model of political economy that can be used to analyze sovereign borrowing. Accordingly, a version of the dynamic tragedy of the commons model by Tornell and Velasco (1992) is extended and simplified. It is shown the same economic forces that generate overspending in a tragedy of the commons model can guarantee that a small open economy repays its sovereign debt even when the only punishment available to credits is the exclusion from future international lending. Hence, the model provides a direct answer to the well known paradox of sovereign debt, exposed by Bulow and Rogoff (1989). The model thus is capable of generating debt endogenously and tied the sustainability of debt to precise parameters like the number of political groups or regions in a country, the discount rate of the agents in the country and the economic benefits of savings.
The next steps will relax several of the assumptions in the model, introducing risk aversion being one of them. Also, it is of interest to understand how different political systems might alter the results. The final step would be to test the empirical predictions generated by the model, relating the political structure to the amount of lending that model generates, as well as exploring its welfare implications.