Current account and public debt implications of market distortions under structural rigidities

The development experience of a number of African and other developing countries has been characterized by policies of market interventions, agricultural taxation, and stateled industrialization in import substituting sectors. This paper investigates the potential implications of these policies for the current account and public debt of a small open economy with structural rigidities. I find that the current account dynamics associated with unsustainable public debt creation and distortionary tax finance of the government budget are nonunique, possibly nonmonotonic, and sensitive to private expectations regarding future policy. The paper also shows that in the presence of adjustment frictions, distortionary tax finance of government expending could lead to nonmonotonic government debt dynamics with an initial fall followed by an unsustainable expansion. Thus, short horizon government policies could lead to explosive public debt dynamics. This possibility seems pertinent for a number of African countries where the constant threats of military coups and political overthrow are unlikely to have been conducive to fostering governments with long horizons.