Political Economy of Sovereign Debt: A Theory of Cycles of Populism and Austerity

Alessandro Dovis, Mikhail Golosov, Ali Shourideh

NBER Working Paper No. 21948
Issued in January 2016
NBER Program(s):   EFG   IFM   POL 

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.