Essays on the Political Economy of Crisis and Reform

Abstract

The severe political and economic repercussions of the during the last decade have revealed the necessity for an improved understanding of both the determinants of sovereign debt crises and the political economy of structural reforms. This dissertation, which consists of three self-contained papers, contributes to these research areas. In the first paper, we investigate the interaction of fiscal federalism and sovereign default risk. Numerous countries with chronic external debt problems are characterized by inefficient federal fiscal structures. However, the impact of a country's federal design on sovereign default risk has barely been studied in previous work. This paper aims to address this gap. We develop a stylized model of a federation in which regions borrow individually from international lenders while the central government decides whether to default on aggregate sovereign debt. We show that decentralized borrowing leads to higher debt levels, at higher bond yields, an increased default probability and lower welfare compared to a benchmark scenario of centralized borrowing. Moreover, differing regional default costs further increase aggregate welfare losses through distorted regional borrowing incentives. Case studies of Argentina and the euro area illustrate the channels described in the model. The second paper analyzes how domestic distributional incentives influence sovereign default on debt held by foreign creditors. In a simple political economy model, we show that external default can serve as a redistributive policy similar to distortionary income taxation. The channel we derive builds on recent evidence which suggests that the output costs of default are mainly incurred by high-income households, whereas relatively poor ones benefit due to smaller public spending cuts. Although the potentially important role of income heterogeneity among domestic agents has attracted comparatively little attention in previous work, historical evidence is in line with our argument. In the third paper (with Johannes Brumm), we argue that an important determinant of voters' support for economic reform is the strength of family ties. While the crisis hypothesis predicts that crises facilitate reform, we show in a political economy model that this relation can break down, and even reverse, when agents take into account the effect of reform on their family members. Applied to southern European countries with strong family ties, the model rationalizes why the extremely high (youth) unemployment following the Great Recession has not led to more substantial labor market reforms. In such countries austerity might block rather than foster additional structural reforms.