In a famous paper, Kydland and Prescott (1977) show that when policymakers announce a low-inflation policy, agents will expect high inflation, as long as the marginal cost for policymakers of additional inflation in the future is low compared to the marginal benefits of pushing output temporarily above its normal level. The reason this happens is because the policymakers discretion to change policy in the future makes the announcement of a low-inflation policy not dynamically consistent (equivalently, it is not subgame-perfect).
I could not help thinking about this issue when I read yesterday’s statement by the heads of state or government of the euro area and EU institutions, which stated in point 6 that regarding private sector involvement Greece “requires an exceptional and unique solution” and in point 7 that “all other euro countries reaffirm their inflexible determination to honour fully their own individual sovereign signature and all their commitments”.
Didn’t the Greek government commit in the past to fully honour their responsibilities? Nevertheless, yesterday’s agreement requires private sector involvement in terms that some consider a selective default. If Merkel thinks that the political cost of not involving the private sector is too high now, why should markets believe that Germany will have a different view if Portugal needs additional EU financing sometime in the future?