Inflation-default trade-off without a nominal anchor: The case of Greece

We investigate the debt sustainability implications of leaving a currency union in the context of the Grexit phenomenon. Using a common currency debt specification that is calibrated to the 2001-2010 episode of the Greek economy, we obtain default in year 2012 as an endogenous outcome in a baseline event analysis. Next, we consider a Grexit scenario in which the government issues both euro and drachma denominated sovereign debt and has the option to inflate away its nominal debt obligations by discretion. In the Grexit economy, lenders charge an ex ante inflation risk premium while buying drachma debt with the anticipation of an ex post inflationary bias. Consequently, in order to obtain drachma debt shares that are representative of the Greek economy in the pre-eurozone episode, we assume that the sovereign now borrows in segmented bond markets and the inflation risk premium on drachma debt is counterbalanced by a risk aversion premium asked by lenders of euro debt. We find that outright default would be avoided in 2012 if drachma was announced as a national currency. However, despite default is avoided, the aversion premium on euro debt shrinks the revenue raised by debt issuance in large amounts and reduces welfare. (Copyright: Elsevier)