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

I examine the role of households' precautionary savings motive in amplifying and propagating movements in sovereign spreads. I study this mechanism in a model where the government of a small open economy borrows from foreigners, but the debt is then partially held by heterogeneous domestic savers. In a calibration to Spain in the 2000s, I find that default risk accounts for about half of the output contraction. More generally, sovereign risk exacerbates volatility in consumption over time and across agents, creating large and unequal welfare costs even if default does not materialize. (JEL E21, F41, G51, H63)