Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

The policy maker announces what priority the government will give to debt repayments.

2. 
   Investors hear the announcement and form expectations about how likely the government is to repay them, which determines the interest rate at which they’re willing to lend.
   

3. 
   The government decides whether to repay the debt or not.
   

In Stage 1 the policy maker announcing that the government will give the highest possible priority to repaying its debts makes sense. The policy maker hopes that investors believe the announcement and only demand a small risk premium in order to lend to the government. But a problem occurs in Stage 3: if the policy maker has discretion and finds herself in tough economic times, she may prefer to take the easy option and default.

Investors aren’t stupid; they realise that the announced policy isn’t what counts: it’s what the policy maker is going to do in the case of tough economic times. If the policy maker has discretion as to whether or not to repay the investors, when times are hard she may face irresistible pressure to default. This is true even if the investors have lent to the government at a low interest rate. Knowing this, investors demand a much higher risk premium in order to lend to the government (which paradoxically increases the probability that it’s going to default!).


But if the policy maker has to abide by some preset rules, she can convince the investors that even if times are hard they’ll be repaid, so she really can follow through on her promise. As a result, her government can borrow at low interest rates and investors are more likely to be repaid.


Solving the Problem: Tying Your Hands Voluntarily

In this section, we show that tying your hands by committing to the rules can

be better than having full discretion, because it can change individuals’ expectations in an advantageous way. Removing the discretion solves the troublesome time inconsistency problem (that we describe in the preceding section).