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 sovereign default risk and political turnover. 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 exercise we apply the model to Greece and find that bailout episodes are characterized by an increased risk of political turnover. In the short run, stricter conditionality raises the risk of sovereign default because it reduces the participation rate in bailout programs. In the long run, however, stricter conditionality limits the accumulation of debt which lowers sovereign default risk. We show that the frequency of political turnover is U-shaped in the strength of conditionality.