This study investigates the impact of fiscal contractions on investment dynamics, with a particular focus on the risk of “investment collapses.” Using an unbalanced panel of 107 countries over the period 1960–2023, we construct an investment-collapse indicator based on extreme declines in investment share and identify fiscal contraction shocks based on movements in government spending relative to its historical floor. This study uses a distributed lag framework with Driscoll–Kraay robust standard errors to account for spatial and temporal dependencies while controlling for human capital, institutional quality, and output growth. We find evidence of intertemporal trade-offs, whereby fiscal contractions are associated with an increased likelihood of sharp declines in investment in the impact year. This collapse is followed by a reversal in the subsequent year, suggesting a stabilizing effect that prevents the persistence of extreme downside risk. The results are robust to conditional fixed-effects-based logit specifications and when subjected to stricter shock thresholds.
AC et al. (Mon,) studied this question.
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