Working Paper: NBER ID: w29667
Authors: Marina Azzimonti; Nirvana Mitra
Abstract: We study how political constraints, characterized by the degree of flexibility to choose fiscal policy, affect the probability of sovereign default. To that end, we relax the assumption that policymakers always repay their debt in the dynamic model of fiscal policy developed by Battaglini and Coate (2008). In our setup, legislators bargain over taxes, general spending, debt repayment, and a local public good that can be targeted to the region they represent. Under tighter political constraints, more legislators have veto power, implying that local public goods need to be provided to a larger number of regions. The resources that are freed after a default have to be shared with a higher number of individuals, which reduces the benefits from defaulting in per-capita terms. This lowers the incentive to default compared to the case with lax political constraints. The model is calibrated to Argentina and the results conform to robust empirical evidence. An event study for the 2001/2002 sovereign debt crisis shows that political constraints had an important role in the buildup that led to the crisis.
Keywords: No keywords provided
JEL Codes: D72; E43; E62; E65; F34; F41; F44; H2; H4; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| smaller minimum winning coalition (C71) | overborrowing (H74) |
| overborrowing (H74) | higher perceived risk of default (G32) |
| higher perceived risk of default (G32) | raises borrowing costs (E43) |
| less constrained governments (H19) | more rewarding default (G40) |
| dynamic incentives related to future local public goods provision (H73) | affects current default incentives (E43) |
| tighter political constraints (D72) | lower sovereign default probability (F34) |