Some macroeconomic effects of nationalizing private sector foreign debt

Abstract

In the recent debt crisis years, many governments have adopted foreign debts of their domestic private sectors. This paper uses a simple small open economy version of Blanchard's (1985) overlapping generations model to demonstrate that such a policy encourages the accumulation of national foreign debt and can contribute to higher inflation. Because individuals have finite lives they fail to fully internalize the government's intertemporal budget constraint. Current generations therefore regard the debt relief as an increase in wealth. They raise consumption which causes current account deficits. Future generations have to lower consumption to service the additional debt. The debt service takes the form of a higher inflation tax. If the government tries to stabilize exchange rates while nationalizing debt, both the debt and inflation problems are exacerbated.