ABSTRACT:
The recent eurozone crisis put forward the discussion of whether countries that faced unsustainable sovereign debt trajectories should have left the euro area rather than to default. 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 alternative Grexit scenarios in which the government issues both foreign as well as local currency denominated sovereign debt and has the option to inflate away its nominal debt obligations by discretion. We find that given the severity of macroeconomic fundamentals in year 2012, default was inevitable even if drachma was announced as a national currency. This is because (i) it takes time to build enough drachma debt to be able to inflate away local currency debt burdens to obtain meaningful fiscal relief and (ii) lenders charge an inflation risk premium to the sovereign ex ante, with the anticipation of an inflationary bias ex post under discretionary monetary policy. Our analysis sheds light on the trade-offs between outright default or inflating away the economy, while accounting for the reciprocal feedback between discretionary inflation and endogenously determined currency structure of sovereign debt.