Manuel Amador, "A Political Economy Model of Sovereign Debt Repayment". Abstract:
"Bulow and Rogoff (1989) show that a country that has access to a sufficiently rich asset market cannot commit to repay its debts and therefore should be unable to borrow. This is because for any debt contract, there exists a time at which the country is made better off by defaulting and replicating the payoffs of the debt contract through savings in the asset market. This paper provides an answer to this paradox based on a political economy model of debt. It shows that the presence of political uncertainty reduces the ability of a country to save, and hence to replicate the original debt contract after default. In a model where different political parties alternate in power, an incumbent party with a low probability of remaining in power has a high short-term discount rate and is therefore unwilling to save. The current incumbent party realizes taht in the future whoever achieves power will be impatient as well, making the accumulation of assets unsustainable. This time-inconsistency is shown to be equivalent to the problem faced by a hyperbolic consumer. Because of their inabilty to save, politicians demand debt ex-post and the desire to borrow again in the future enforces repayment today."Posted by DeLong at January 20, 2003 08:54 AM | TrackbackI agree that the math works. But I don't understand the logic of the argument. Isn't the desire to borrow again in the future also downweighted by the hyperbolic form of discounting? Isn't repayment now in order to preserve the option to borrow in the future a form of saving? Why doesn't political competition disable this form of saving as well?