How a savings shortfall can lead to a recession

When a country has a savings shortfall, it needs to borrow from the rest of the world to finance its investment and therefore its external deficit. If the rest of the world stops lending to this country (because uncertainty or risk aversion rises, because the country’s external debt becomes excessive), the only solution is for the country to wipe out its external deficit, which requires a contraction in domestic demand and therefore a recession. This contraction can be obtained via a depreciation of the exchange rate (and a deterioration in the terms of trade), a rise in interest rates or a restrictive fiscal policy. This situation has been faced for example by the peripheral euro-zone countries from 2010, Brazil from 2014 and Turkey from 2018.