Insufficient or excessive investment under sovereign default risk

Abstract

Private agents do not internalize the impact of their investment decisions on the sovereign’s bond prices and default risk. Therefore, a standard externality argument implies that investment is insufficient and that a subsidy can improve welfare, if financed by non-distortionary means. We contrast this logic with a countervailing force. When the sovereign is impatient relative to households, plausibly due to political economy factors, it finds laissez-faire capital accumulation excessive and might prefer instead to tax it. We embed both mechanisms in a sovereign default model with decentralized capital investment, long-term public debt, and stochastic trend growth, calibrated to salient features of the Spanish economy. We find that the impatience channel dominates quantitatively, to such an extent that laissez-faire is preferable to the government’s ideal fiscal policy, based on households’ welfare.