Self-fulfilling debt crises, fiscal policy and investment

Abstract

This paper studies the circular relationship between sovereign credit risk, government fiscal and debt policy, and output. I consider a sovereign default model with fiscal policy and private capital accumulation. I show that, when fiscal policy responds to borrowing conditions in the sovereign debt market, multiple equilibria exist where the expectations of lenders are self-fulfilling. In the bad equilibrium, pessimistic beliefs make sovereign debt costly. The government substitutes borrowing with taxation, which depresses private investment and future output, increases default probabilities and verifies lenders' beliefs. This result is reminiscent of the European debt crisis of 2010-12: while recessionary, fiscal austerity may be the government best response to excessive borrowing costs during a confidence crisis.

Review of Policies for Indonesia’s Electricity Sector Transition and Qualitative Evaluation of Impacts and Influences Using a Conceptual Dynamic Model

“…Alternatively, the government can pursue green financing through loans and bonds [128,129]. Funding through debt should be treated with caution, especially in developing countries, as it could lead to increased taxation and, in turn, reduce consumption and investment [130].…”

Underinvestment and capital misallocation under sovereign risk

“…Timing and multiplicity.-The above timing assumption rules out multiplicities of equilibria studied by Cole and Kehoe (2000) and by Galli (2021). In Cole and Kehoe (2000) lenders first offer a price schedule and then the government chooses whether to issue 𝐵 1 and repay 𝐵 0 or to default.…”

“…For certain regions of the state space this allows for two equilibria: one in which optimistic lenders offer a generous price schedule and the government repays and one in which pesimistic lenders refuse to purchase 𝐵 1 and the government defaults. In Galli (2021) lenders observe the amount of debt issued and offer a price before investment is chosen. Lenders' beliefs about investment can be self-fulfilling due to the effect of fiscal policy on households.…”

“…In my environment slow capital accumulation results from the household's inability to internalize how investment improves borrowing terms, while in theirs the cause is the risk of expropriation. Building on Cole and Kehoe (2000) , Galli (2021) studies an economy in which low investment from the private sector can be the result of self-fulfilling beliefs about high default risk. I make timing assumptions that allow me to rule out the sources of multiplicity introduced by these two papers, which highlights that the externalities I study are orthogonal to theirs.…”