Some simple game theory

by on May 7, 2011 at 7:45 am in Economics, Political Science | Permalink

…if any one euro zone country were to start exiting the euro, there would be bank runs on the other fiscally ailing countries. The richer European Union nations know this, and so they are toiling to keep everyone on board. But that conciliatory approach creates a new set of problems because any nation with an exit strategy suddenly has enormous leverage. Ireland or Portugal [or Greece!] need only imply that without more aid it will be forced to leave the euro zone and bring down the proverbial house of cards. In both countries, aid agreements already are seen as a “work in progress,” and it’s not clear that the subsequent renegotiations have any end in sight, because an ailing country can always ask for a better deal the following year.

That is from meToday’s Bloomberg headline reads: “EU Finance Chiefs See More Aid for Greece, Reject Euro Exit.”  Yet a stable game this is not.

1 Badger May 7, 2011 at 8:25 am

There’s so much I disagree with in this article that I’m not even going to try.
I’ll just say that I’m invested long term on the other side of the bet, and that on the long term only one side can make money out of it. Looks like we’ll have to wait and see.

2 Dave May 7, 2011 at 8:58 am

I think Milton Friedman beat you to the punch by about 12 years on that analysis…

3 jk May 7, 2011 at 10:02 am

Why is the Euro still high relative to the dollar? I think this signals that the PIG (minus S) are not important enough or consequential piece of the Euro economy. In other words, they (the PIG nations) are and will be stuck in the Euro and will bend to the agenda of the richer and economically stable EU countries.

Greece is trying to play “the mad man” with exit announcement but the richer nations easily see through the bluff.

4 Badger May 7, 2011 at 11:20 am

It looks obvious to me that the fallout from exiting the Eurozone would be so hugely disastrous in the case of Greece that it would only serve to reinforce all other countries’ commitment to the currency. It would probably help the region to achieve fiscal discipline. The game theory here is simple, but not the kind of simple imagined by Cowen.
Although Friedman was one of the greatest monetary economists of all times, in fact he got this one partially wrong, as these 12 years have proven.

5 Scott Sumner May 7, 2011 at 11:34 am

These recent posts on Greece and Ireland are very interesting. Perhaps this is a naive question, but did Greece plant the der Spiegel story to scare the markets on Friday afternoon (and thus to strengthen their negotiating position?)

6 Maximilian May 7, 2011 at 1:59 pm

The only ones to exit the Euro is either Germany or maybe Germany, France and Benelux. Eventually to join the Swiss.

7 Andy May 7, 2011 at 8:06 pm

In the short term if the Greeks (or Portuguese, or Irish) jump ship the Euro will gyrate, but in the medium and long term it will strengthen greatly. This is why it is HIGH relative to the US$ – which Obama and Geithner are desparately trying to flush down the toilet and make Greece look stingy.

Let’s say the Greeks bail on the Euro. This destroys capital in many banks (which own now worthless bonds) and they have to suck more money out of the economy or get freshly printed money from their governments. Either it is deflationary or neutral for the Euro, and if neutral, the governments get 70 billion euros or more of ‘free money’ to pay THEIR debts with.

Once this is done the Germans will DEFINITELY be in the Euro driver’s seat, meaning a permanently strong euro with NO INFLATION EVER.

So after the short term gyration, the Greeks will get to find out just how well the economy worked in pre-Mycanaean times circa 4000 BC, Portugal, Ireland etc. will come to understand that there truly IS an economic death penalty and will suddenly become Teutonic in their zeal for austerity, and the euro will attain the kind of rock-solid stability formerly associated with the Deutschmark or Swiss Franc.

8 Mulberry May 8, 2011 at 4:57 am

It would probably help the region to achieve fiscal discipline. The game theory here is simple, but not the kind of simple imagined by Cowen.

9 Formal Models > Verbal Reasoning May 9, 2011 at 4:00 am

Your NYT article is an excellent example of the core advantage of formal models over verbal reasoning: all payoffs are laid out explicitly in formal models. Your article fails to consider the payoffs to a PIg if they were the first country to exit the Euro zone. Yes, P and I could potentially be facing bank runs if g decided to pull out, but g faces a potential economic collapse if it pulls out. Second, as Andy points out, the risk to the Euro of a PIG country pulling out is in the short term. Long term, the remaining countries would be more fiscally stable than if the Euro continued to include PIG. There is certainly risk involved in a PIg pulling out of the Euro for the remaining members, but G would likely do fine. That’s big G as in Germany. So the likely outcome is not a PIg pulling out, but Germany paying PIg the equivalent of the risk they would incur if one of them pulled out of the euro zone, and more if as it would seem they’re risk averse.

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