11 - Government domestic debt and the risk of default: a political–economic model of the strategic role of debt

Summary

Introduction

Until recently, most research and controversy on macro fiscal policies was about when and whether debt-financed government deficits have real effects on aggregate output and employment. This problem has typically been studied in a model of a representative agent (or overlapping generations of representative agents) interacting with a benevolent government maximizing a Social Welfare Function. Naturally, only a limited set of issues (such as the role of fiscal policy in favouring optimal capital accumulation or in minimizing the deadweight loss of distortionary taxation) can be addressed within this framework (see Blanchard and Fischer, 1989, for an extensive discussion of this approach). Thus, a particularly important aspect of fiscal policy suppressed in this model is the (intragenerational) redistributive effect of fiscal policy and the consequent political conflicts arising from these distributional concerns. Behind the representative agent lurks a lot of heterogeneity, whether in terms of income and asset-holdings or of preferences. This paper focusses on the question of how differences in income and asset-holdings give rise to differences in preferences concerning fiscal policy and investigates how democratic political institutions solve the social choice problem of what fiscal policy to implement, when agents have conflicting preferences.

Our model is much inspired by the experience of public debt management and the political conflicts surrounding it in several European countries during the interwar period. This was a time when one of the major problems confronting the various governments was how to deal with the huge debt-overhang problem inherited from World War I.