Foreign vs. domestic public debt and the composition of government expenditure: A political-economy approach

We consider an economy in which a political-support maximizing government takes into account different generations’ preferences when deciding how much to borrow abroad and how much to spend on public consumption and investment. We show that, in equilibrium, the government’s choices are shaped by three parameters: the effect of government spending on output, the expected output costs of a default, and the relative political weight of the generations currently alive. We conclude that the joint dependence on these parameters establishes a strong, but non-linear relationship between the share of foreign debt in total public debt and the share of investment in total government spending. ∗Johannes Gutenberg University Mainz, Gutenberg School of Management and Economics, Jakob-Welder-Weg 4, 55128 Mainz, Germany, phone: +49 6131 39 22 55 9, email: [email protected]. [email protected]. We are indebted to Sigrid Röhrs and audiences at the WHU CEUS Workshop, the Silvaplana Workshop on Political Economy and the EPCS conference in Cambridge for helpful comments.