Researchers have studied the possibility that reputation spillovers to other valuable relationships may be costly enough to enforce repayment (Cole and Kehoe (1995), (1996)). Several other explanations of why countries repay their debts have been proposed. Bulow and Rogoff conclude: “loans to LDCs are possible only if the creditors have either political rights, which enable them to threaten the debtor’s interests outside the borrowing relationship, or legal rights.” So, if international asset markets are rich enough, countries will always default on their debts. This sequence of savings is possible as long as the capital markets offer a menu of assets indexed on the same contingencies as the original debt contract. At that point, the country would default and start a sequence of savings in a way that perfectly replicates the original debt contract but generates extra income (the interest that is not paid). The idea behind their argument is simple and illuminating: in any debt contract there is a point in time where a country’s borrowing capacity is (or comes very close to being) maximized. They show that if countries are able to save in rich asset markets, then reputation considerations alone cannot enforce repayment and countries will eventually default on any debt contract. This explanation was revisited by Bulow and Rogoff (1989). Therefore, the desire to borrow in the future induces the country to pay back its debts today. 2 A defaulting government loses access to the international capital markets and default is costly because the country will be unable to smooth consumption later on. Eaton and Gersowitz (1981) formalize this idea in the context of a small country subject to income shocks. The oldest explanation is that they must maintain a good reputation in the international capital markets in order to be able to borrow more in the future. This gives rise to the question: Why do sovereign debtors pay back their debts? Sovereign debt is fundamentally different from private debt because a government cannot generally pledge valuable collateral and the ability to enforce a judgment is extremely limited. The history of sovereign lending os characterized by three broad facts: governments have at times been able to borrow substantial amounts of funds abroad much of what they borrowed was eventually repaid and repayment was often complicated, involving delay, renegotiation, public intervention, and default. This enforcement mechanism is moot for autocratic regimes. Because of their inability to save, politicians demand debt ex-post and the desire to borrow again in the future enforces repayment today. This time-inconsistency is shown to be equivalent to the problem faced by a hyperbolic consumer. The current incumbent party realizes that whoever gains power in the future will also be impatient, making the asset accumulation unsustainable. In a model where different parties alternate in power, an incumbent party with a low probability of remaining in power has a high short-term discount rate and is, therefore, unwilling to save. It shows that the presence of political uncertainty reduces the ability of a country to save and, hence, replicate the original debt contract after default. This article provides an answer to this paradox based on a political economy model of debt. This is because for any debt contract, there exists a time at which the country is made better off by defaulting and replicating the payoffs of the debt contract through savings in the asset market.
Bulow and Rogoff (1989) show that a country that has access to a sufficiently rich asset market cannot commit to repay its debts and therefore should be unable to borrow.