The impact of bailouts on political turnover and sovereign default risk

Abstract

This paper develops a stochastic dynamic politico-economic model of sovereign debt to analyze the impact of bailouts on political turnover and sovereign default risk. We consider a small open economy in which the government has access to official loans conditional on the implementation of austerity policies. There is a two-party system in which both parties care about the population’s welfare but differ in an exogenous utility cost of default. Political turnover is the endogenous outcome of the individual voting behavior. In a quantitative application to the Greek economy, we find that bailouts amplify political turnover risk, which, in turn, elevates sovereign interest spreads. While stricter conditionality fosters the probability of political turnover and sovereign default in the short run, it may mitigate political turnover and default risk in the long run. The frequency of political turnover is U-shaped in the strength of conditionality.