The run up to the euro currency initiated a period of capital inflows into southern European countries, i.e., Spain, Portugal, Italy and Greece. We document that those countries, and only them among OECD countries, concomitantly experienced a decline in the quality of their institutions. We confirm the joint pattern of capital inflows and institutional decline in a large panel of countries. We show theoretically that this joint pattern naturally follows from a "soft budget constraint" syndrome wherein persistently cheap external funding undermines incentives to maintain good institutions - understood here as the degree of government commitment not to support inefficient firms. Low institutional quality ultimately raises the share of inefficient firms, which lowers average productivity and raises productivity dispersion across firms - the typical pattern of productivity in southern Europe over the period under consideration.
