From Political Wedges to Debt Accumulation

Mohades, Siavash (2026): From Political Wedges to Debt Accumulation.

Abstract

This paper develops a quantitative theory of how political distortions in fiscal policy generate public debt accumulation inside a currency union. The model has two member states that share a common monetary authority. The North government maximises resident welfare. The South government maximises a weighted average of welfare and incumbent vote share, which biases fiscal policy toward targeted transfers and away from broad public goods. The numerical solution closes the fiscal block with a reduced-form stationary debt rule around calibrated debt targets. In the baseline calibration, the political distortion lowers South public goods by about 45% relative to a benevolent South government and implies a consumption-equivalent welfare cost of 3.23% per period. A one-time adverse South political shock raises South debt by 0.56% relative to its steady-state level at peak, equivalent to about 0.68 percentage points of steady-state South output. Eight consecutive adverse political shocks raise South debt by about 4.43% relative to steady-state debt, equivalent to about 5.37 percentage points of steady-state South output. The mechanism is a deterioration in the primary balance caused by politically motivated transfer expansion. This pattern is robust to alternative home bias, vote sensitivity, political transfer elasticity, and debt targets. Additional exercises show that tighter fiscal rules reduce debt volatility but do not remove the underlying distortion, while an endogenous sovereign spread breaks local determinacy under first-order perturbation.

• Item Type: MPRA Paper
• Language: English
• Keywords: Political distortions; fiscal policy; public debt; currency union; targeted transfers; fiscal rules.
• Subjects: D - Microeconomics > D7 - Analysis of Collective Decision-Making > D72 - Political Processes: Rent-Seeking, Lobbying, Elections, Legislatures, and Voting Behavior; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E61 - Policy Objectives ; Policy Designs and Consistency ; Policy Coordination; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F45 - Macroeconomic Issues of Monetary Unions; H - Public Economics > H6 - National Budget, Deficit, and Debt > H63 - Debt ; Debt Management ; Sovereign Debt

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