Sovereign Debt Booms in Monetary Unions

After joining the the euro, several countries with a history of high inflation (notable examples include Greece and Italy) experienced sharp reductions in inflation together with a prolonged build up of sovereign debt. In this paper we propose a rationalization for this phenomenon. To do so, we explore the interaction between inflation credibility and the debt dynamics that arise when an impatient sovereign issues nominal bonds. We are particularly interested in the impact of an increase in inflation credibility, achieved either through better policies and institutions or by leveraging the higher inflation credibility of other countries via a currency union. We show that an increase in inflation credibility delivers an invitation to borrow, raising the maximum borrowing limit of the country and reducing any incentive to save. Conditional on a nominal interest rate, the government has an ex post incentive to inflate away the real value of its bonds. However, creditors anticipate this temptation ex ante, pricing the ex post inflation into the nominal interest rate. The country therefore bears the cost of high inflation with no reduction of debt in real terms. Including the costs associated with ex post inflation, a country with low inflation credibility will bear a greater burden from a given level of debt. In such a scenario the government has an incentive to save and reduce debt over time to a level that eliminates the temptation to inflate. On the other hand, if the government is impatient relative to the market interest rate, it has an incentive to borrow and increase debt over time. This conflict between ‘impatience’ and ‘saving to escape inflation’ generates a cut-off level of debt below which the government will save and above which, it will borrow. That is, debt dynamics diverge around this cut-off, to the left of which debt shrinks and to the right of which debt grows. One way to think about the above is through the elasticity of the nominal interest rate to debt levels. As the government accumulates debt, its nominal interest increases, reflecting the increase in the temptation to inflate. That positive elasticity can be high enough to stop the country from accumulating more debt at the margin, and thus it generates an endogenous force that breaks the borrowing dynamics generated by impatience. When inflation credibility is high, and, as a result, the government is not tempted to inflate, then this elasticity force is reduced. As a result, the government borrows over time all the way up to its maximum debt limit. There is a range of debt levels over which the government will choose to save and reduce debt over time in a low inflation credibility regime but choose to borrow and increase debt over time in a high inflation credibility regime. That is, a switch from low to high inflation credibility can turn governments from savers to borrowers.1 In this sense we can rationalize why a country that gains the higher inflation commitment of a monetary union can end up with a sovereign borrowing boom, as was witnessed for some countries in the euro zone.2