Long Term Debt and the Political Support for a Monetary Union

Abstract

This paper examines the role of long term debt for the political support of a monetary union or, more generally, an inflation-reduction policy. The central idea is that the decision about membership in the union leads to a redistribution between debtors and creditors, if they are holding long term debt with a nominally fixed interest rate, as well as tax payers. For example, if joining the union means a decrease in the inflation rate, creditors should favor joining while debtors should be against it. A government of a high inflation country might strategically try to exploit this effect by selling more long term debt denominated in its own currency at a fixed nominal rate rather than a foreign currency such as the Dollar (or, almost equivalently, as floating-rate debt or rolled-over short-term debt) to its citizens. We show that the effect on political support is unclear. While the "creditor effect" of increasing the number of agents holding domestically denominated debt helps generating support for joining the union, the "tax effect" of having to raise more taxes in order to pay for the increased real debt payments after a successful monetary union works in the opposite way. The paper then studies a number of special cases and ramifications. The case of Italy is examined more closely. The paper argues that recent debt management policy in Italy is probable to have eroded the political support for actions aimed at enhancing EMU membership chancesmonetary integration;national debt;monetary policy;inflation