Bailouts, inflation, and risk sharing in monetary unions

The ongoing debt crisis in the Eurozone has raised an obvious question: why would low debt members of a monetary union, such as Germany, choose to bailout members with high debt, such as Greece? In this paper I propose a novel mechanism that explains this behavior. In particular, I build a theoretical model of a monetary union with a continuum of member countries and a single central bank that sets a union-wide inflation rate and cannot commit to monetary policy. Countries are subject to idiosyncratic income shocks, and the fiscal authority in each country may issue or purchase nominal bonds in response to these shocks. In equilibrium, countries with high income shocks will purchase debt issued by countries with low income shocks. The central bank will try to use surprise inflation to devalue the nominal debt of member countries who are net borrowers, as this will tend to decrease consumption inequality between households in debtor countries and creditor countries. Since the primary motive for surprise inflation is redistribution, creditor countries can forestall costly surprise inflation by bailing out debtor countries, as this reduces between-country inequality and dampens the central bank's desire to redistribute. Creditor countries received favorable income shocks and debtor countries received bad income shocks, so these bailouts function as a risk sharing arrangement between countries. Bailouts will also reduce the equilibrium value of inflation, and hence they unambiguously improve a country's welfare from an ex ante perspective. In this environment, creditor countries only agree to make bailouts ex post because they share monetary policy with debtor countries. The model then also offers a new theory of why countries would choose to form a monetary union: a common monetary policy provides the incentives required for risk sharing. Countries can achieve more risk sharing when their income shocks are less correlated, so this mechanism offers a counterweight to the usual Friedman-Mundell logic for optimal currency areas, wherein countries with more positively correlated business cycles stand to gain the most from forming a monetary union.