Sovereign default, political instability and political fragmentation

Abstract

This paper studies sovereign borrowing and default in an economy in which self-interested political parties bargain over the budget and there is political turnover. The model generates an endogenous distribution of resources that depends on borrowing decisions, and policymakers become short-sighted. The party in power, as well as the coalition members, obtain a higher share of aggregate consumption as leverage increases. Very small changes in these shares generate non-negligible shifts in the default/repayment sets. This mechanism provides an explanation for why governments increase their leverage and default more frequently, in comparison to a model with a constant distribution of resources.