Political instablility and seigniorage: An inseparable couple — or a threesome with debt?

• Published date: 01 February 2019
• Date: 01 February 2019
• DOI: http://doi.org/10.1111/roie.12379
• Author: Frank Bohn

Rev Int Econ. 2019;27:347–366. wileyonlinelibrary.com/journal/roie

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INTRODUCTION

Among the political turbulences and with ongoing (84%) inflation, Russia defaulted on its (GKO)

bonds in 1998. The International Monetary Fund (IMF) stepped in with a loan and inflation went

down in the following year. Similarly, Ecuador lost financial market access in 2000; the IMF approved

a financial package and inflation went down. In Tanzania, the IMF had already facilitated loans in

2003, before Tanzania lost financial market access in 2004. Nonetheless, the inflation rate went down

again, albeit from an already low level.1

What do these countries have in common? Owing to the loss in credibility associated with their

financial restructuring, they suffer a financial squeeze. In Russia, for instance, the total federal budget

in 1998, the year the government defaulted on its bonds, shrank in dollar terms to the size of the gov-

ernment budget of the Irish Republic. A desperately needed increase in tax revenues is typically not

feasible; the tax base is relatively small and there are tax collection inefficiencies that cannot be over-

come in the short run. The only other public finance resources are “moderate” inflationary finance

Received: 29 March 2018

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Revised: 11 August 2018

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Accepted: 17 August 2018

DOI: 10.1111/roie.12379

ORIGINAL ARTICLE

Political instablility and seigniorage: An inseparable

couple — or a threesome with debt?

Frank Bohn

Department of Economics, Institute for

Management Research,Radboud University,

Nijmegen, The Netherlands

Correspondence

Frank Bohn, Radboud University, Institute

for Management Research, Department

of Economics, P.O. Box 9108, 6500 HK

Nijmegen, The Netherlands.

Email: f.bohn@fm.ru.nl

JEL Classification: E62, F34, F41, H61

Abstract

In the literature, political instability is shown to raise sei-

gniorage and/or debt, but there is no debt‐seigniorage trade‐

off. However, what happens when the IMF gets involved?

Based on a political economy model of intertemporal public

finance this paper presents qualitatively new and robust re-

sults. First, political instability causes myopic government

behaviour and produces more debt, not more seigniorage.

Second, IMF policies requiring debtor countries to achieve

both monetary and fiscal stability at the same time are inef-

fective. Third and surprisingly at first sight, debt condition-

ality aiming at monetary stability is particularly effective in

heterogeneous societies with unstable governments.

This is an open access article under the terms of the Creative Commons Attribution‐NonCommercial License, which permits use, distribution

and reproduction in any medium, provided the original work is properly cited and is not used for commercial purposes.

© 2018 The Authors. Review of International Economics published by John Wiley & Sons, Ltd.

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BOHN

(seigniorage) and debt from the IMF or other international financial institutions. Many countries that

find themselves in such a fragile situation also suffer from political instability. If we take the “Political

Instability and Absence of Violence/Terrorism” index from the World Bank’s (2015a) Worldwide

Governance Indicators data set, the aforementioned countries Tanzania and Ecuador were in the low-

est 20 to 26 percentile in the year they lost market access. Another particularly pointed example of

political instability is Russia with its five changes of government between March 1998 and August

1999 without Duma or presidential elections.2 In summary, these countries are politically unstable

and they manage to obtain more external debt, but do not tap into seigniorage as an additional source

of revenue.

This paper points out that the aforementioned cases are not well understood. What is discussed

in the literature refers to debt in general, not IMF debt. It is shown that, under political instabil-

ity, governments typically raise seigniorage and/or debt—in particular, there is no debt‐seignior-

age tradeoff. When the IMF gets involved, such a monetary‐fiscal policy trade‐off does, however,

occur in some Latin American countries and elsewhere including the aforementioned examples.

This paper offers one possible explanation which hinges on IMF conditionality. A simple political

economy model of intertemporal public finance is used to illustrate the mechanism. More generally,

this paper calls for a broader reevaluation of countries’ alternative decisions on seigniorage and

debt, including, but not limited to situations in which the IMF gets involved and IMF conditionality

is applied.

In their seminal article Cukierman, Edwards, and Tabellini (1992) argue that political instability

leads to higher levels of seigniorage, a claim that has been left unchallenged since. They present empiri-

cal evidence that is supported by a theoretical model; the level of seigniorage chosen depends on current

tax collection inefficiencies that can only be overcome in the future (by investing in a tax collection

technology now). In their model, political instability is treated as an exogenous probability of losing

power. Their model suggests that governments in more unstable countries “may deliberately choose

to maintain an inefficient tax system, so as to constrain the behavior of future governments ...” which

will then have to “collect a larger fraction of their revenues through seigniorage ... .” In their model,

the incumbent government focuses on current period gains rather than longer‐term gains, because the

longer‐term gains may not fully accrue to itself. Such short‐sightedness and lack of discernment for the

longer‐term interests of society as a whole will, henceforth, be referred to as myopic government be-

haviour. Cukierman et al.’s (1992) core idea is then that more political instability leads to more myopic

government behaviour which, in turn, translates into higher levels of seigniorage, that is, less monetary

stability. Additional empirical support, both for seigniorage and inflation, is provided by Edwards and

Tabellini (1991).

An alternative line of reasoning posits that government myopia can lead to higher levels of defi-

cit or debt. The literature emphasizes the strategic role of domestic debt for electoral success (for

instance, Aghion & Bolton, 1990; Persson & Tabellini, 1990) and/or concludes that governments

may borrow excessively when there is a chance of being voted out of office in the next period (for

instance, Alesina & Tabellini, 1990; Persson & Svensson, 1989; Tabellini & Alesina, 1990). Özler

and Tabellini (1991) explicitly capture default on sovereign debt and distinguish a constrained and an

unconstrained scenario. Only in the latter can political instability lead to an increase in borrowing.

Additional support for the political (and economic) determinants of budget deficits is provided by

Edwards and Tabellini (1991) and Roubini (1991). They also find evidence for a positive correlation

between deficit and seigniorage.

With the aforementioned articles the debate seemed to have come to an end. Nothing was said

about a negative correlation, that is, a potential trade‐off between debt and seigniorage (or inflation)

under political instability. In 2013, Agnello and Sousa (2013) argued that political instability increases