Electoral Uncertainty and the Volatility of International Capital Flows∗

I study a small open economy in which electoral uncertainty affects and is affected by capital inflows. Two candidates, one favoring workers and another favoring entrepreneurs, run for office; the winner chooses tax policy, which affects investment returns. A pro labor electoral victory results in a "sudden stop" in investment and capital flows, reflecting a time inconsistency problem. While the pro business candidate does not suffer from time inconsistency, she becomes less attractive to voters if the costs of external credit and the foreign debt are larger. Hence the probability distribution of the electoral outcome depends on the size of the external debt, which itself depends on that distribution. I characterize the model’s politico economic equilibria and find several implications. Politico economic links exacerbate the responses of financial variables to exogenous shocks. Self fulfilling equilibria may exist. Policies that alleviate the pro labor candidate’s commitment problem, such as pre electoral policy agreements, contribute not only to financial stability but also, and perhaps more surprisingly, to the chances of a pro labor victory in the elections. ∗I am indebted to Nouriel Roubini and Alfredo Thorne for useful discussions on the Brazilian experience, and to Andres Velasco and participants of seminars at Pompeu Fabra, Cornell, Columbia, Princeton, the NY Fed, and the LACEA meetings for comments and suggestions. I acknowledge and thank the National Science Foundation’s financial support. Of course, the views, errors, and shortcomings here are my sole responsibility. †Department of Economics, Rutgers University, New Brunswick NJ 08901. Email: [email protected] Electoral Uncertainty and the Volatility of International Capital Flows