Just the One: Time Inconsistency and the Greek Bailout(s)

As EU decision-makers grapple with their response to an imminent Greek debt default or bailout, they need to consider not only their current decisions but also their likely future decisions. It is critically important that they not deceive themselves into thinking that they (or the Greek government) can commit to making all their future decisions now. There are strong grounds for positing time-inconsistency in EU and Greek government decision-making concerning the Greek bailout. This is a simple point, but critically important to good policy planning in this situation. Acknowledging time-inconsistency does not proscribe any particular policy choice, but it encourages policy makers to act cautiously.

There are two distinct sources of time-inconsistency in this environment: one is game-theoretic and the other is decision-theoretic.  The game theoretic source arises from the precommitment problem, also called the problem of non-credible threats. Often in an intertemporal game a player would benefit if he could credibly commit to a particular future move, even though that move will not be optimal at the later date.  So for example a monopolist will benefit now if it can credibly commit to lowering prices later after a new entrant chooses to pay a set-up cost to enter the market.  If this were a credible commitment by the monopolist it would dissuade any entrants. However new entrants know that the precommitment is not credible – after the entrant has paid the cost to enter the market, the monopolist is better off keeping prices relatively high and sharing duopoly profits.  The monopolist might claim that it will lower prices against new entrants — “we will never be undersold!” — even though this is not an incentive-compatible claim. Entrants may ignore these incentive-incompatible claims depending upon the nature of the game. Game theorists call this type of publicly-communicated threat about a planned strategy “cheap talk.”   Cheap talk may affect the equilibrium of a dynamic game, or it may not.

The EU made a solemn promise never to bail out any member government, in order to prevent any member government from over-spending in anticipation of an EU bailout.  In game-theory terminology, this was “cheap talk” by the EU – the term sounds flippant but is not meant that way.  This solemn promise will soon be broken in the case of Greece.  Now, the EU would like to commit to bailing out the Greek government only once, thereby forcing Greece painfully to restructure its public finances quickly in the face of the severe consequences for Greece of an all-out default at a later date. The EU is likely to make a solemn promise along these lines after this first bailout. In the eventuality that Greece does not painfully restructure and faces all-out default at a later date, the EU will then want to bail it out a second time, but will try to commit to not bail it out a third time, etc.  I predict that there will be either two or three rounds of this game played over the next few years (counting the first bailout as round one).  Meanwhile, the Greek government will be playing a somewhat similar game strategy of cheap-talk-without-credible-threats against its own claimants (public sector unions, pensioners).   

There is a second, equally-important, source of time-inconsistency in this environment.  The Greek government, and perhaps the EU as well, cannot be modelled as decision-makers with intertemporally consistent preferences obeying the Bellman principle of optimality.[1]  The Bellman principal requires that if we ask an intertemporal decision-maker a time t about his preferred choices at time t+k, he gives us the same answer now as he would give at time t+k if he had the same information. Anyone (myself included) who has made plans to visit the pub on Friday night and have “just the one” and then wakes up Saturday morning, having had many more than one, has intertemporally-inconsistent preferences.[2] In 2010, the Greek government may sincerely want to force through painfully tough budgets for 2011 – 2012, but this does not mean it will want to do that in 2012.  At that point, it may sincerely want to force through tough budgets for 2013 – 2014 but not 2012.  This kind of intertemporal inconsistency is a feature of human nature, as well as of social and political institutions.     


[1] In intertemporal decision-making the Bellman principal allows us to replace unknown future decisions with contingent-optimal ones.

[2] Flann O’Brien has a wonderful comic sketch about the paradoxical, mutually-supportive relationship between the phrases “just the one” and “never again” in pub culture, but I cannot find the reference.

10 thoughts on “Just the One: Time Inconsistency and the Greek Bailout(s)”

  1. They will be panicked into it. IMF just said that the bailout will cost €120bn not €40bn and Lenihan now has to find €1bn not just €400m.

    The best thing to do with Greece is stabilise it and ‘kick it out of the Eurozone’ before it is our turn in the firing line or Spains..bless 🙂

  2. There but for the grace of God…

    Shouldn’t Ireland call the IMF immediately. The country doesn’t need the money right now, but it would be good to have a back-stop in place ahead of any potential (sic probable) sovereign funding problem.

    Get the funding line in place, have the nasty detail on terms spelled out to the public, in particular the civil servants, ahead of time. And then, don’t take the 3% money of the IMF if the 5% money is still available in the capital markets.

    Or would this just be inviting the barbarians inside the gates? (sic assuming they aren’t in Ireland already).

  3. Our own inconsistency may be best here London Reader, whatever the realities of our comparative fundamentals the international focus has refocused to Spain and Portugal. I’d think a premature move to call the IMF, while for you outlined reasons sensible, would risk alerting markets that our situation is even worse than advertised increasing the likelihood of a debt cost spiral.

  4. Calling the IMF is a bad idea, they will call you and give you a number to ring 🙂

    Next up is the €1bn contribution we must make to the Greek Bailout. It was €400m of a €40bn bailout but the IMF now say the bailout is €100-€120bn

    Thoughts

    1. Do not increase the €400m to €1bn. Contagion ensues when de furriners find out Lenny is skint.
    2. Increase the bailout pledge to €1bn and we have a finance minister pledging expenditure of €1bn with no prior parliamentary or cabinet approval …not that anybody notices with all the glugging noises coming out of the Developers SPV. Unconstitutional but who cares, not Cowen.
    3. We will have to finance the €1bn at much higher rates of interest …whatever we offload 3 years at. 5% ?????

  5. On Rating agencies this quote hit’s the nail on the head.
    “Paul McCulley noted that the debt crisis (the shadow banking system, subprime mortgages, SIVs, etc.) was the equivalent of an under-age drinking party with the rating agencies handing out fake IDs.”

  6. @Darren
    @2Pack

    If the only reason not to call the IMF preemptively is because this might highlight Ireland’s difficult situation, I fear the aim has already failed. CDS Spreads lock step with Portugal highlight people know Ireland’s finances are troubled.

    What other reasons are their?

    NTMA has borrowed 60% of what the Exchequer needs for 2010 (pre-bailouts to Greece and Irish Banks). But that leave circa €8+ bn more to find at a reasonable rate by year end.

  7. L_R I take what you’re saying and you may well be right. I still feel that our fundamentals while troubled would seem to be just about weatherable so long as borrowing costs public and private remain reasonable. We are for now rated better than Portugal and Spain and were not downgraded with Spain by S&P today. On the realities of our current situation this should continue to be the case. Therefore the fear is that costs will spiral based on both an exaggerated perception and momentum of increased costs exacerbating the situation and leading to a cycle successive deteriorations and increaced borrowing costs.

  8. London Reader and I are broadly agreed.

    I would observe that we must find our ‘share’ of a putative Greek bailout and as we ‘own’ 1.6% of the ECB we must find an amount =(0.016*(total bailout of ummm €150bn – IMF cash)) over the next three years ….so that would mean that Lenny has to pledge around €1.6-€2bn.

    Not offering the pledge is not an option but just wait to see what the morkeshes do when they hear that we found yet another borrowing opportunity.

  9. Presumably the ‘new lenders’ will never want their loans to be repaid and could not care about interest payments either. Right?

    Repaying your loans requires a significant surplus of income over expenses. So could someone please advise me as to how this financial miracle will be made manifest in GR, ES and IRL. I see only two prospects: nil and zero!

    Some very misguided persons have advocated financial and economic ‘waterboarding’ of an aggregate of human beings as the way to resolve these debt problems. So you subject your fellow citizens to severe financial stress – to whose benefit? Why?

    These situations will end very badly indeed if there is an insistance that our Business-as-Usual economic model shall triumph over the health and wellbeing of individuals. Individuals – in aggregate, ARE the economy!

    B Peter

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