Working Paper: NBER ID: w7575
Authors: Michael Kremer; Paras Mehta
Abstract: This paper examines the effect of reduced transaction costs in the international trading of assets on the ability of governments to issue debt. We examine a model in which governments care about the welfare of their citizens, and thus are more inclined to default if a large proportion of their debt is held by foreigners. Reductions in transaction costs make it easier for domestic citizens to share risk by selling debt to foreigners. This may increase tendencies for governments to default, and thus raise their cost of credit and reduce welfare. We find that even in the absence of transaction costs, home bias in placement of government debt may persist, because in the presence of default risk the return on government debt is correlated with the tax burden required to pay the debt. Asset inequality may reduce this home bias, and by increasing foreign ownership, increase incentives for default. Finally, if foreign creditors are less risk averse than domestic creditors, there may be one equilibrium in which domestic creditors hold the asset and default risk is low, and another in which foreign creditors hold the asset and default risk is high.
Keywords: No keywords provided
JEL Codes: F0; F3; H6
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Reduced transaction costs (D23) | Increased foreign ownership of government debt (H63) |
| Increased foreign ownership of government debt (H63) | Increased likelihood of government default (H74) |
| Reduced transaction costs (D23) | Increased likelihood of government default (H74) |
| Increased foreign ownership of government debt (H63) | Increased tax burden necessary to service the debt (H69) |
| Asset inequality (D31) | Increased likelihood of government default (H74) |
| Creditor risk preferences (G33) | Increased likelihood of government default (H74) |