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Inflating the Beast: Political Incentives Under Uncertainty

  • Ricardo J. Caballero
  • Pierre Yared

The standard view of the political economy of public debt is that myopic and unconstrained politicians prefer to disregard intertemporal smoothing considerations and extract political rents as fast as possible. From this perspective, it seems that the world has much to celebrate, as most emerging market economies -- often suspect of having weak political institutions -- have chosen to save rather than waste most of their exceptional income from high commodity prices. Unfortunately, the optimistic conclusion that these countries may have turned the corner with respect to public resource management may be premature. In this paper we show that while it is true that in the long run there is a negative connection between the level of public debt and the quality of political institutions, this needs not be the case in the short run. Quite the opposite, in the short run, governments with weak political institutions are likely to save more than governments with better institutions facing the same uncertainty. This is due to an option value of rent-seeking whereby the prospect of potentially squandering funds in the future makes governments more "precautionary" today. We show that this result relies on three assumptions: Economic risk is high relative to political risk, markets are sufficiently incomplete, and there exists a rent-less policy-making regime.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13779.

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Date of creation: Feb 2008
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Handle: RePEc:nbr:nberwo:13779
Note: EFG IFM POL
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  1. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
  2. V. V. Chari & Patrick E. Kehoe, 1990. "Sustainable Plans and Mutual Default," IMF Working Papers 90/22, International Monetary Fund.
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  4. Lizzeri, Alessandro, 1999. "Budget Deficits and Redistributive Politics," Review of Economic Studies, Wiley Blackwell, vol. 66(4), pages 909-28, October.
  5. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
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  7. Chari V. V. & Kehoe Patrick J., 1993. "Sustainable Plans and Debt," Journal of Economic Theory, Elsevier, vol. 61(2), pages 230-261, December.
  8. Bohn, Henning, 1990. "Tax Smoothing with Financial Instruments," American Economic Review, American Economic Association, vol. 80(5), pages 1217-30, December.
  9. Daron Acemoglu & Michael Golosov & Aleh Tsyvinski, 2008. "Political Economy of Mechanisms," Econometrica, Econometric Society, vol. 76(3), pages 619-641, 05.
  10. Ricardo Caballero & Stavros Panageas, 2005. "A Quantitative Model of Sudden Stops and External Liquidity Management," NBER Working Papers 11293, National Bureau of Economic Research, Inc.
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