Financial Globalization, Inequality, and the Rising Public Debt

During the last three decades government debt has increased in most developed countries. During the same period we have also observed a significant liberalization of international financial markets. We propose a multi-country model with incomplete markets and show that governments may choose higher levels of debt when financial markets become internationally integrated. We also show that public debt increases with the volatility of uninsurable income (idiosyncratic risk). To the extent that the increase in income inequality observed in some industrialized countries has been associated with higher idiosyncratic risk, the paper suggests another potential mechanism for the rise in public debt.