Sovereign Debt Booms in Monetary Unions

Abstract

After joining 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.