External Debt, Capital Flight and Political Risk

This 1989 Journal of International Economics paper by Alberto Alesina and Guido Tabellini explains the simultaneous accumulation of public external debt and private capital flight observed in developing countries (mainly Latin America) in the 1970s-80s as the rational outcome of political polarization and uncertainty. In a two-period general-equilibrium model, two parties with conflicting distributional goals – a “workers” government and a “capitalists” government – randomly alternate in office; whichever group controls government in period 2 expropriates the other group’s domestic capital income through taxation. Because the currently governing party does not internalize the cost that its own borrowing imposes on the other group’s constituency once political control may pass to that other group, each type of government borrows abroad up to its exogenous credit ceiling and transfers the proceeds to its own supporters, who in turn use part of the windfall to acquire external assets as insurance against the risk of future expropriation – generating capital flight and depressed domestic investment side by side with public overborrowing. The model further predicts that left-wing (workers’) governments, but never right-wing (capitalists’) governments, impose binding capital controls, and that allowing for strategic debt repudiation preserves the overborrowing result while showing that repudiation is observed in equilibrium specifically when a left-wing government unexpectedly takes office with a high level of inherited debt.

Guido Tabellini | Macro Paper Warehouse

External Debt, Capital Flight and Political Risk