Monday, March 15, 2010

Yet Another Post on Sovereign Debt and Democracy

. Monday, March 15, 2010

Dr. Oatley disagreed with my post on democracy and sovereign debt, and cited some of his own recent research to smack me down. I don't disagree with a word of what he wrote. (And believe it or not, I noticed that that paper -- which I had previously read -- had just come out, but was waiting to post on it until he had a chance to.) I also don't think anything he wrote contradicts anything I wrote.

Why does he think it does? It's my fault. I used the phrase "democracies are exceptionally prone to the sort of time inconsistency problems that lead to things like debt crises" but didn't clarify what I meant by "exceptionally prone" (although "the sort of time inconsistency problems" was intended to temper the statement). I did not mean that democracies have the same perverse incentives that autocracies have with regards to accumulation of sovereign debt. In fact, I meant the opposite: democracies have completely different perverse incentives to accumulate sovereign debt than do autocracies, and this leads to different kinds of debt problems. What does that mean? For one thing, it means that democracies should be less prone to massive accumulation of sovereign debt than autocracies, but they should be more prone to debt shocks. Let's flesh this out.

Democracies face time-inconsistency problems stemming from the fact that democratic leaders are in principle-agent relationships with their constituents. Autocracies are not. So when autocracies increase sovereign debt it is often to confer rents to autocratic leaders and their cronies. An autocratic leader will have no trouble committing his citizens to austerity if necessary to pay down debt (or attract more loans) so long as he is safe in power, because those costs are not borne by him. Even if he defaults and is unable to secure future loans he may draw down funds funneled into Swiss bank accounts while the credit was flowing and live well. Or he may massively inflate his currency in an attempt to service his debts, which is another form of austerity. Indeed, autocratic leaders may wish to promote austerity, according to Acemoglu & Robinson (2006), if it will help maintain their domestic position.

Democratic leaders face incentives to spend in deficit, but also to not accumulate so much debt that austerity or default is required. Citizens in democracies are able to demand (and receive) social welfare spending programs that have automatic stabilizers built in. So in the event of a revenue shock like a major recession or demographic shift, democracies will be prone to a sudden debt crisis. Citizens accustomed to welfare spending (and the public sector employment that entails) will be loathe to give it up and may punish politicians that attempt to impose austerity (see Greece and Iceland right now, and Latin American democracies in the 1980s). They may be less concerned with the long-run effects that default will bring, or they may be better able to get "bridge loans" that tide them over until economic recovery without requiring austerity conditions.

Dr. Oatley acknowledges that Greece was not in his sample, but how about the other countries under discussion: Italy, Ireland, Spain, Portugal? No, because they aren't developing countries. The Baltic states? No, because during most of the sample period they were still part of the USSR. On the other hand, the Latin American countries that experienced debt crises in the 1980s and 1990s, many of which were democracies, were included in his analysis.

The point is that even if I can't generalize from Greece to the whole world, I may be able to generalize from Greece to other similar countries. Like those Muir suggests, and I was referring to originally, that are relatively new democracies, were recently autocracies and often have violent civil conflict within recent memory.

Off the top of my head I can't recall any research that addresses this question directly (perhaps readers can illuminate), but it seems like it maps fairly well to me and is congruent with Dr. Oatley's research because it asks a somewhat different question.


Anonymous said...

I agree with your analysis. It's interestng that four decades after becoming a democracy that Portugal is now saddled down with high debt.I think democracies inherently have a hard time saying no to their citizens.

Yet Another Post on Sovereign Debt and Democracy




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