## The Poisoned Chalice of Debt

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**Canonical URL:** [The Poisoned Chalice of Debt](https://www.imf.org/-/media/files/publications/fandd/article/2024/06/aguiar.pdf)

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### Overview
- Since the 1970s, emerging market and developing economies have aggressively tapped global sovereign debt markets to jump-start growth or cover transitory shortfalls in output and tax revenue.
- A balanced sample of 52 developing and emerging market economies shows the ratio of external sovereign debt to GDP rose dramatically between 1970 and the mid-2000s; over the last 20 years of the sample this trend partially reversed.
- Key periods and samples cited:
  - 1970–2004: period of large increases in debt.
  - 2004–22: later period in which average debt-to-income decreased for some countries.

### Empirical evidence on growth, investment, and volatility
- Core empirical patterns:
  - Countries with external public savings (foreign reserves exceeding external debt) experienced faster growth, while those that borrowed experienced stagnation (1970–2004 sample).
  - Over longer horizons, countries that borrow show more volatility in government expenditure and private consumption.
  - There is a positive relationship between changes in debt and volatility of spending, indicating more borrowing is associated with more volatile public spending.
  - The correlation between debt reduction and growth does not hold uniformly: in 2004–22, countries that decreased debt relatively more had slower growth; reductions sometimes resulted from debt forgiveness or default and restructuring.
- Interpretation of cross-country differences:
  - Countries with large levels of debt differ in political institutions and other fundamentals besides debt level.
  - History that led to a given debt level matters (starting from low debt in 1970 differs from low debt due to forgiveness or default).

### Theoretical interpretation: neoclassical paradigm vs present-bias political model
- Neoclassical paradigm predictions:
  - Access to global capital markets should facilitate investment and smooth government spending across shocks, leading to faster growth and less volatile spending.
- Evidence contradicts the neoclassical predictions:
  - Data show the opposite: sovereign borrowing is associated with lower long-run growth and investment and greater volatility in spending.
- Present-bias political model (Aguiar with Amador and Gopinath; Aguiar, Amador, Fourakis):
  - Political incumbents with present bias prefer spending while in office, leading to excess borrowing when political checks are weak.
  - Large public debt induces taxation of private activity (including private investment and capital income), crowding out private investment and retarding growth.
  - Lenders price debt to break even on average; spreads over risk-free rates increase when a recession is likely and decrease in a boom, inducing governments to borrow more in booms than in busts — producing procyclical fiscal policy.
  - Governments default when debt is high and output is low; default leads to exclusion from markets and reductions in output.

### Welfare consequences and counterfactuals
- Quantitative-model findings and thought experiments:
  - Models of sovereign debt with volatile government income, default costs, and impatient governments can replicate large run-ups in debt and subsequent defaults.
  - If private citizens are relatively more patient than their governments, restricting government access to sovereign debt markets can increase citizen welfare.
  - Simple calculations (following Aguiar with Manuel Amador and Stelios Fourakis) show that modest disagreement about discounting the future can yield the result that the citizenry would be better off if the government were denied access to debt markets.
  - Making debt markets more efficient is beneficial only if citizens and governments share discounting and risk evaluations; otherwise, removing frictions may worsen outcomes.

### Lender-of-last-resort, runs, and tradeoffs
- Debt markets are vulnerable to runs/self-fulfilling panics analogous to bank runs: a failed auction to roll over maturing debt can force default.
- Role of a third-party lender of last resort (for example, the IMF in the international context):
  - A promise to lend in the event of a failed auction can eliminate panic outcomes by assuring lenders they will not be the only ones burned.
  - Without such a third party, lenders demand a high premium to cover run risk, constraining government borrowing and potentially increasing average citizen welfare by limiting impatient governments.
  - Tradeoff: a lender of last resort can prevent panic but may enable excessive borrowing by present-biased governments; models with runs indicate citizens who are not excessively impatient may prefer no lender of last resort despite exposure to panics.

### Policy implications and recommendations
- Principal implication: proceed with extreme caution in facilitating sovereign borrowing in developing and emerging markets.
- Potential policy responses:
  - Raise the threshold for interventions in a crisis (i.e., be more selective about becoming a lender of last resort).
  - Reconsider the welfare costs of direct lending and the design of conditional lending facilities.
  - Recognize that allowing easier access to international debt markets can increase volatility and lower investment when political economy distortions are severe.
  - Prioritize research into the costs and consequences of sovereign borrowing to refine policy tools and thresholds.
- Overarching guidance: skepticism toward the neoclassical promise that sovereign borrowing reliably funds investment and smooths shocks; evaluate market access and crisis intervention policies against political-institutional realities and citizen-versus-government time preferences.

*Source: “The Poisoned Chalice of Debt,” Mark Aguiar, F&D, JUNE 2024.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2024/06/aguiar.pdf_