Financial Globalization and the Rising of Public Debt

During the last three decades the stock of government debt has increased in most developed countries. During the same period we also observe a significant liberalization of international financial markets. In this paper we propose a multi-country political economy model with incomplete markets and endogenous government borrowing and show that governments choose higher levels of public debt when financial markets become internationally integrated. We also show that government debt increases with the volatility of uninsurable idiosyncratic income (risk). To the extent that the increase in income inequality observed in some industrialized countries during the last three decades has been associated with higher idiosyncratic risk, the paper suggests another potential mechanism for the rise in public debt.