inflation. intuitively, the logic of the fiscal theory can be described as follows : let us assume additional expenditure, for instance higher transfers, which are not financed by additional taxes but by issuing additional bonds. consequently the value of real debt is now higher than the present value of future tax payments. households feel richer and thus consume more, causing output and inflation to increase. monetary policy has to stabilise real debt to avoid an inflation spiral, with the result that it responds at a rate of less than 1 to 1 to inflation, thereby violating the taylor principle. thus, higher inflation reduces debt in real terms and lower real interest rates reduce the real debt service burden of existing government debt. in each of the two cases, a regime of fiscal dominance is characterised by higher inflation and probably also more volatile inflation. monetary policy is no longer able to control the inflation rate, and therefore welfare losses will occur. however, the story does not end here. remaining within the world of theory, we can continue as follows : because economic agents are forward - looking, it is quite possible that the consequences i have just described could manifest themselves before the economy has entered the regime of fiscal dominance. looking ahead, public debt cannot be accumulated forever. sooner or later, governments that run large deficits for a long period of time risk hitting a fiscal limit – a point at which government revenues can no longer be increased to stabilise government debt. this inability to raise revenues might have economic reasons, such as a crossing of the peak of the laffer curve. but there might also be political reasons that make it infeasible to raise taxes. certainly, the actual fiscal limit is highly uncertain in many ways : it is a probability distribution rather than a point and depends on expectations, shocks and policy measures taken. [ 5 ] and forward - looking agents know : once the government hits the fiscal limit, either an adjustment of fiscal spending or an adjustment of monetary policy needs to occur. otherwise debt cannot be stabilised. and as a consequence, monetary policy might come under pressure to step in and stabilise government debt. thus, even if fiscal policy has not yet reached its limit, the economic mechanisms attached to the fiscal theory of the price level might already swing into action. to be specific : let us assume that agents expect, with some probability, that monetary policy will bear the burden of adjustment and stabilise real government debt through higher inflation. once inflation expectations start rising, the same might happen with inflation

of psi. this consensus implies, in particular, that private creditors should be treated in a manner that is comparable to bilateral official creditors ( paris club ) and that, among the group of private creditors and investors, no category of lenders should be considered inherently privileged. furthermore, the framework rightly insists on psi relying as much as possible on voluntary solutions. in this respect, it is helpful that the prague communique recognises the possibility of a temporary payment suspension in the event of private creditors ’ unwillingness to cooperate fairly with the debtor country. consequently, the imf can continue to support a defaulting member country within existing access limits, provided the debtor is seeking to work cooperatively and in good faith with its private creditors and is meeting other programme requirements. in contrast to the strict psi rules for restructuring cases, the prague framework admits that exceptional access to imf financing, combined with policy adjustment, would be justified in the event of capital account problems if and when the fund believes that confidence among market participants can be restored quickly. in addition, the imf may encourage private creditors to help contain such crises voluntarily. however, the fund would have no coercive role should voluntary psi in the form of debt rollovers remain unsatisfactory. while the prague approach was applied successfully in a number of recent financial crises in smaller insolvent countries ( pakistan, ukraine, ecuador ), the underlying distinction between solvency problems and liquidity problems quickly displayed its inherently political dimension when argentina, the second most important borrower among all emerging market economies, was hit by a confidence crisis at the end of 2000. early in 2001, the imf - pushed by its major shareholders - provided exceptionally large financial support almost automatically, despite the serious doubts fund staff must have had from the outset regarding argentina ’ s longer - term solvency. in september 2001, the imf ’ s exceptional financial support was even further enhanced. in november 2001, it was acknowledged indirectly that the approach taken in the case of argentina was not actually in line with the prague communique. anne krueger, the fund ’ s first deputy managing director, publicly made the point that, in her opinion, there remains a gaping hole in the international financial architecture as long as we lack incentives to help countries with unsustainable debt restructure their maturities promptly and in an orderly way. given this gap, anne krueger justified bailout operations as the only available mechanism to deal with solvency problems