DP8668 | Sovereign debt, government myopia, and the financial sector

Publication Date

01/11/2011

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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.