Financial market liberalization and the rise in income of the super-rich are a significant cause of too much government indebtedness says recent paper published by the Philadelphia Fed.

“In this paper we study a multicountry politico-economic model where the incentives of governments to borrow increase both when financial markets become internationally integrated and when inequality rises. We propose this mechanism as one of the possible explanations for the growing stocks of government debt observed in most of the advanced economies since the early 1980s. We have also conducted a cross-country empirical analysis using OECD data, and the results are consistent with the theoretical predictions,” write authors Marina Azzimonti, Eva de Francisco, and Vincenzo Quadrini.

How so?

Financial market liberalization induces lower elasticity of the interest rate meaning that as the market for debt enlarges the rise of new net debt is proportionally smaller to the overall market then it would be in a closed, autarkic situation. In other word, open and large financial markets cause interest rates to be less responsive to new government debt issuance.

“The difference is that in autarky the interest rate is determined only by domestic debt… With mobility, the interest rate is a function of average worldwide debt… Therefore, when the domestic government considers a change in B’ [new debt], the induced change in worldwide debt… is smaller than in the autarky regime… Effectively, the worldwide interest rate is perceived by each individual government as being less elastic to its own supply of bonds. This changes the (individual) incentive to issue debt because the marginal increase in the repayment costs R is lower,” explain the authors.

This approach also explains why so many small economies, particularly in the EU, found debt as a great substitute for consumption.

“Since small countries face a larger world market relative to their own economy, they perceive the world interest rate as less sensitive to their own per-capita debt. As a result, they issue more debt,” note the authors.

In both country sizes, explain the authors, the workers and the entrepreneurs both look positively on borrowing.

For workers, the financial liberalization lowers the rate at which they can borrow but over a longer period, workers’ “consumption stabilizes at a lower level than the consumption in the autarky steady state. This is because the higher debt implies higher payment of interests and, therefore, lower transfers to workers (which become negative in the long run).”

As a result, welfare gains from liberalization, in the long run, accrue to the entrepreneurs (graph below)

Now, many authors argue that that financial liberalization is the direct cause of the rise in the super-rich but in this paper, the authors treat the super-rich, euphemistically referred to as an income inequality event, as a separate variable apart from the financial liberalization.

Financial liberalization, explain the authors, increases idiosyncratic risk, an event detrimental to smoothing of the entrepreneurial income and wealth. As the idiosyncratic risk rises, entrepreneurs prefer more government debt so that they can park their wealth into and derive risk-free income from government debt paper.

For the super-rich, in essence, government debt is an insurance policy that preserves their huge wealth, income and status while shifting risk associated with such wealth onto a larger debt-fiduciary pool that provides such insurance.

The authors also provide some numbers of these effects.

“The increase in income inequality is generated by a higher volatility of the idiosyncratic risk, which changes from [delta] = 0.91 to [delta] = 0.984. As described above, [delta] = 0.91 was chosen to generate the 6% concentration of income at the top 1% in the autarky steady state. The new value is chosen to have a share of 9% for the top income earners in the steady state with capital mobility,” say the authors.

As a result see, “the increase in inequality (ignoring liberalization), increases long-term debt from 30% of income to about 55% of income. If we focus instead on capital liberalization alone (keeping inequality constant), long-term debt increases to 51% of income. When the two changes are considered together, long-term debt increases to 73%,” calculate the authors.

Nor is the private debt an equal substitute for the public one.

“If governments have higher credit capacity than workers, then the economy with public debt will not be equivalent to the economy with private debt since the latter will have zero or insufficient private debt,” say the authors.

Finally a note on sovereign debt crisis…

“If debt crises are more likely to arise when the stock of public debt is higher, then the growth in government borrowing induced by capital markets liberalization and increased income inequality may contribute to trigger a sovereign debt crisis,” say the authors but the extent of that is altogether another paper.

Available here.