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The Political Economy of Sovereign Default

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Sebastian Hohmann

Conclusion

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1My thesis has investigated the implications of political constraints on government discretion for sovereign borrowing and default. This topic has current relevance as democratically elected governments across Europe try to convince their populations that averting defaults is worth tremendous costs. Further, the empirical evidence on defaults points to the willingness of countries to repay, as distinct from their economic ability to do so, as an important factor in bringing about defaults. Some countries default at very low debt levels that have not been difficult do manage for other countries. I have argued that a common explanation can be found for these two facts in countries’ political institutions. These institutions function as a transmission mechanism that convert the economic costs of defaults into political costs for governments. In a theoretical model of the political economy of default, I have sketched the workings of this mechanism. I have concluded that governments that depend for support on small groups of supporters drawn from a large population of potential backers can be more certain of continued loyalty than governments dependent on large groups. More loyal support translates into greater government discretion to default. To test my theoretical hypothesis, I have used a number of dependent variables, ranging from government debt crises over long-term interest rates on government bonds to sovereign ratings. The results were mixed, but suggest that enlarging the pool of potential backers, which results in greater government discretion in my model, increases the likelihood of external debt crises. Splitting the sample using the a fixed-effects panel threshold estimator, I found evidence of the hypothesized relationship for long-term interest rates in the case of countries with debt burdens below a threshold of around 61% of GDP. I interpreted this as reasonable, since government discretion is more likely to play a role when governments have “economic room” to exercise it, i.e. when policy choice is not eliminated by large debt burdens.

2Given the highly political nature of default decisions, further research in this area needs to emphasize the link from economic to political costs. Using the Selectorate theory was a first crude step in this direction, but far more work is needed. Models must move away from the quasi-static framework I have employed and fully endogenize taxation and the political costs of servicing debt in a dynamic framework, possibly accounting for politicians facing term-limits. Preferences over tax rates necessary for the repayment of debt play a key role in this regard, which implies that the income distribution, which may not necessarily coincide with the distribution of political influence in an economy, also matters. Countries politically dominated by wealthy interests may be more ready to repay when the high taxes necessary for this fall on a disenfranchised poor majority without wealth at stake. Above all, improved, preferably non-categorical measures of institutions are needed to subject political economy models to more rigorous empirical tests.

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