Research / BFI Working PaperMar 17, 2020

When is Debt Odious? A Theory of Repression and Growth Traps

Viral V. Acharya, Raghuram Rajan, Jack B. Shim

How is a developing country affected by its government’s ability to borrow in international markets? We examine the dynamics of a country’s growth, consumption, and sovereign debt, assuming that the government’s objective is to maximize short-term, typically wasteful, expenditures. Sovereign debt can extend the government’s effective horizon; the government’s ability to borrow hinges on its convincing investors they will be repaid, which gives it a stake in the future. The lengthening of the government’s effective horizon can incentivize it to adopt policies that result in higher steady-state household consumption than if it could not borrow. However, access to borrowing does not always improve government behavior. In a developing country that saves little, the government may engage in repressive policies to enhance its debt capacity, which only ensures that successor governments repress as well. This leads to a “growth trap” where household steady-state consumption is lower than if the government had no access to debt. We argue that such a model can explain the well-known negative correlation between a developing economy’s reliance on external financing and its economic growth. We also analyze the effects of instruments such as debt relief, a debt ceiling, and fiscal transfers in helping a developing economy emerge out of a growth trap, even when governed by a myopic, possibly rapacious, government.

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