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Debt defaults: the role of political institutions

If a nation defaults on its debt, then as well as hurting private creditors, it may find it hard to access credit markets in the future. Emanuel Kohlscheen examines the impact of parliaments and other political institutions on the likelihood that governments will default on their official obligations.

Debt crises are a relatively common phenomenon in emerging markets. Within the past decade, the governments of Russia (in 1998) and Argentina (in 2001) have made the headlines for having defaulted on massive amounts of public debt. But sovereign default is anything but new: it is reported that the Spanish government defaulted on its official obligations no less than 13 times between the fifteenth and eighteenth century; and France too defaulted several times, the last time in 1788.

So what circumstances make a country more likely to default? My research suggests that defaults on debt repayments are a problem of governance just as much as they are a problem of economics. I show that in the last quarter of the twentieth century, the likelihood of default was almost five times higher in countries with presidential political systems than in parliamentary democracies.

What’s more, nine out of eleven presidential countries that reduced their external indebtedness swiftly over the period (by more than 25% of GDP in three years or less) did it via a default. This compares with only one in five parliamentary democracies.

Defaults on debt repayments are a problem of governance just as much as they are a problem of economics

The key difference seems to be the fact that in a presidential system, the head of government does not need the continuous consent of the legislature to remain in power. Under a parliamentary constitution, the possibility of a vote of confidence in the government acts as a powerful incentive to avoid an economic crisis. All else being equal, this institution alone reduces the likelihood of default from 3.9% a year to between 1.8% and 2.7% a year.

Of course, the form of government in a country is not chosen at random. It may be that certain characteristics mean that a country is more likely both to have a presidential system and to default. If so, an association between the two would not be surprising. Most Latin American countries, for example, have adopted presidential forms of government, whereas almost all developed countries have parliamentary constitutions.

My response is twofold. First, I show that the striking difference between presidential and parliamentary systems remains when either the Latin American countries or the developed countries are excluded from the sample. Moreover, the fact that most countries that have reached a high level of economic development are parliamentary democracies might not be a mere coincidence.

I also use a technique known as "propensity score matching," which pairs very similar countries in terms of their cultural, historical and geographical characteristics at the time of independence. The difference in the default rates of these otherwise identical countries supports the idea that it is the parliamentary system of government that is crucial in reducing the likelihood of default.

Parliamentary democracies are far less likely to default than countries with presidential systems

Economic historians Peter Lindert and Peter Morton have noted that "In either worldwide lending crises (the 1930s and 1980-86), the problem debtors tended to be those that had problems earlier." My study makes clear that it is constitutional forms of government that make history so relevant for the development of credit markets. The economic problems of Latin American countries are not so different from those faced by presidential countries elsewhere in the world, including Russia and the Philippines.

So are countries with presidential political systems doomed? Not necessarily. There is nothing that precludes a president from being more trustworthy than a prime minister, even if the latter is constantly checked by parliament. But credit markets under presidential governments could get better insulation from the natural vagaries of the democratic process if debt policy were delegated to an independent committee, just as has happened with monetary policy.

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Further reading

  • Lindert, Peter, and Peter Morton. 1989. "How Sovereign Debt has Worked." in Developing Country Debt and Economic Performance: the World Financial System, pp. 39-106. Edited by Jeffrey Sachs. University of Chicago Press for NBER.