Investment Cycles and Sovereign Debt Overhang

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Investment Cycles and Sovereign Debt Overhang

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Title: Investment Cycles and Sovereign Debt Overhang
Author: Aguiar, Mark; Amador, Manuel; Gopinath, Gita

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Citation: Aguiar, Mark, Manuel Amador, and Gita Gopinath. 2008. Investment cycles and sovereign debt overhang. Review of Economic Studies 76(1): 1-31.
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Abstract: We characterize optimal taxation of foreign capital and optimal sovereign debt policy in a small open economy where the government cannot commit to policy, seeks to insure a risk averse domestic constituency, and is more impatient than the market. Optimal policy generates long-run cycles in both sovereign debt and foreign direct investment in an environment in which the first best capital stock is a constant. The expected tax on capital endogenously varies with the state of the economy and in- vestment is distorted by more in recessions than in booms amplifying the effect of shocks. The government’s lack of commitment induces a negative correlation between investment and the stock of government debt, a "debt overhang" effect. Debt relief is never Pareto improving and cannot affect the long-run level of investment. Further, restricting the government to a balanced budget can eliminate the cyclical distortion of investment.
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