Aggregate Demand and Sovereign Debt Crises

Abstract

Sovereign debt crises coincide with deep recessions. I propose a model of sovereign debt that rationalizes large contractions in economic activity via an aggregate-demand amplification mechanism. The mechanism also sheds new light on the response of consumption to sovereign risk, which I document in the context of the Eurozone crisis. By explicitly separating the decisions of households and the government, I examine the interaction between sovereign risk and the precautionary savings motive. When a default is likely, households anticipate its negative consequences and cut consumption for self-insurance reasons. The resulting shortage in aggregate spending worsens economic conditions through nominal wage rigidities, boosting default incentives and restarting the vicious cycle of high spreads and low demand. I study the implications of this feedback mechanism in a model where the government of a small open economy borrows from foreign lenders but some of the debt is held by heterogeneous domestic savers subject to uninsurable idiosyncratic income risk. I calibrate the model to Spain in the 2000s and find that about a third of the output contraction is caused by default risk. More generally, sovereign risk exacerbates volatility in consumption over time as well as across agents, creating large and unequal welfare costs even if default does not materialize.