Political Economy of Sovereign Debt: A Theory of Cycles of Populism and Austerity
We study optimal fiscal and redistributive policies in an open economy without commitment. Due to its redistributive motives, the government’s incentive to default on its external debt is affected by inequality. We show that in equilibrium the economy endogenously fluctuates between two regimes. In the first regime, the government borrows from abroad, spends generously on transfers and keeps the inequality low. In the second regime, it implements austerity-like policies by cutting transfers, reducing foreign debt and increasing the inequality. The equilibrium dynamics resembles the populist cycles documented in many developing countries.
We thank Andy Abel, Mark Aguiar, Manuel Amador, V. V. Chari, Pablo D'Erasmo, Joao Gomes, Emmanuel Farhi, Larry Jones, Tasos Karantounias, Patrick Kehoe, Juan Pablo Nicolini and Chris Phelan and seminar participants at Carnegie Mellon, EUI, Ohio State, Princeton, Rochester, UPenn, Wharton, 2014 Pizzanomics Conference, SED, Minnesota Workshop in Macroeconomic Theory, Stony Brook Workshop in Political Economy, ITAM-PIER conference, NBER conference on macroeconomics within and across borders for valuable comments. We thank Gaston Chaumont for valuable research assistance. Golosov thanks the National Science Foundation for financial support. Shourideh thanks the Rodney White Center for Financial Research for support. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.