Abstract This paper proposes a new method for measuring the impact of inflation on the real value of public debt. The distribution of debt debasement is based on two inputs: the distribution of privately held nominal debt by maturity, for which we provide new estimates, and the distribution of risk-adjusted inflation dynamics, for which we provide a novel copula estimator using options data. We find that inflation by itself is unlikely to lower the U.S. fiscal burden significantly because debt is concentrated at short maturities and perceived inflation shocks have little short-run persistence and are small.

We propose a simple model of the sovereign-bank diabolic loop, and establish four results. First, the diabolic loop can be avoided by restricting banks' domestic sovereign exposures relative to their equity. Second, equity requirements can be lowered if banks only hold senior domestic sovereign debt. Third, such requirements shrink even further if banks only hold the senior tranche of an internationally diversified sovereign portfolio--known as ESBies in the euro-area context. Finally, ESBies generate more safe assets than domestic debt tranching alone; and, insofar as the diabolic loop is defused, the junior tranche generated by the securitization is itself risk-free.