Bailouts, Inflation, and Risk-Sharing in Monetary Unions
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Bailouts, Inflation, and Risk-Sharing in Monetary Unions Matthew Greenblatt1
Published online: 30 September 2020 © International Atlantic Economic Society 2020
Abstract This paper presents a new rationalization for bailouts of sovereign debt in monetary unions, such as those observed during the recent Euro crisis. It introduces a model where member countries of the monetary union are ex-ante identical, and each derives utility from consumption and disutility from the union-wide inflation rate. The union’s central bank is utilitarian and lacks commitment. Countries borrow or save in a market for nominal sovereign debt in response to idiosyncratic income shocks, with countries that receive positive income shocks saving and countries that receive negative income shocks borrowing. Ex post, the monetary union’s central bank will attempt to devalue sovereign debt through surprise inflation, as this will redistribute income from rich creditor countries to poor debtor countries. Creditor countries choose to bailout debtor countries because bailouts will weaken the redistributive motives of the central bank and forestall surprise inflation. As bailouts in this environment constitute a payment from lucky creditor countries to unlucky debtor countries, they mimic a risk-sharing arrangement that insures against income shocks. The payments made by creditor countries are incentive-compatible due to the shared currency and inflation rate in the monetary union. This ability of countries to provide each other with incentive-compatible insurance constitutes a novel theory of optimal currency areas. This insurance benefit of the monetary union is largest for countries with negatively correlated income shocks, in contrast to the classic Mundell-Friedman optimal currency area criterion. Keywords Euro crisis · Bailouts · Monetary unions · Optimal currency areas Electronic supplementary material The online version of this article (https://doi.org/10.1007/s11293-020-09681-3) contains supplementary material, which is available to authorized users. Matthew Greenblatt
[email protected] 1
The College of New Jersey, Ewing Township, NJ, USA
270
M. Greenblatt
JEL E58 · E63 · F45 · H63 · H81
Introduction Since 2008, thinking on the Euro has been inseparably linked to the Greek debt crisis and the various bailout programs implemented by the Troika (the European Commission (EC), the European Central Bank (ECB) and the International Monetary Fund (IMF)). Greece is not unique among countries that have suffered sovereign debt crises in receiving foreign aid, however, as argued and documented by Bulow and Rogoff (2015), the scale of this aid is unique. Moreover, the governments of other Eurozone members (especially Germany) directly participated in these bailouts, providing rescue funds, as well as the bond purchases and political muscle required for domestic participation in the private sector write-off of Greek debt. These governments also acted indirectly through the EC and the ECB, all of which reinforces the idea that there is something
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