The Political Economy of Domestic and External Sovereign Debt

This paper explores the political and distributional consequences of sovereign debt and default taking into account that a sizable share of public debt is held by domestic creditors. We develop a quantitative macroeconomic model in which heterogeneous households face idiosyncratic income risk and save in non-state-contingent government bonds. Debt contracts are not enforceable and the government is politically constrained in its policy choices: A fiscal plan is required to receive the support of the majority of households. If neither fiscal plan is approved, the government has to default and to restructure domestic and external debt. Debt crises are characterized by a political conflict. In the course of a crisis, rising debt service costs force the government to cut redistributive spending. While wealthy households benefit from high interest rates on their savings, poor households support a default. Consequently, the approval of the fiscal plan decreases and the likelihood of a political default rises. Political constraints generate sizable welfare costs highlighting that individuals do not internalize the impact of their voting on interest rates and redistributive spending in equilibrium.