The Aggregate-Demand Doom Loop: Precautionary Motives and the Welfare Costs of Sovereign Risk

IMF Working Papers, December 18, 2020

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Sovereign debt crises coincide with deep recessions.
The paper proposes a model of sovereign debt that rationalizes large contractions in economic activity via an aggregate-demand amplification mechanism.
The mechanism explains household consumption responses to sovereign risk, documented in the context of the Eurozone crisis.
Key behavioral separation: explicit separation of the decisions of households and the government to examine interaction between sovereign risk and precautionary savings.
When a default is likely, households anticipate negative consequences and cut consumption for self-insurance reasons.
Reduced aggregate spending worsens economic conditions through nominal wage rigidities and increases default incentives, creating a vicious cycle.

Aggregate-demand amplification: precautionary savings by households in response to sovereign default risk reduce consumption and aggregate demand.
Nominal wage rigidities transmit lower aggregate demand into worse economic outcomes, which in turn raise default incentives.
The interaction restarts and amplifies sovereign risk and economic contraction — characterized as an "aggregate-demand doom loop."

The model is calibrated to Spain in the 2000s.
Calibration finding: about half of the output contraction is caused by default risk.
More generally, sovereign risk exacerbates volatility in consumption over time and across agents.
Even if default does not materialize, sovereign risk creates large and unequal welfare costs.

Subject: Consumption, Income, Income distribution, Public debt, Wages
Keywords: aggregate demand, debt price, default, default incentive, default probability, government debt, heterogeneous agents, open economy, precautionary motives, Sovereign risk, WP