Europe's Nash Equilibrium - A Tightly Stretched Rubber Band?

Tyler Durden's picture

In the ongoing 'game of chicken' in Europe (playing out between the core and the periphery as the main two players) it appears we are once again at a point of inflection in the Nash Equilibrium that exists only in the minds of the Eurogroup leaders. The equilibrium is one where no player can unilaterally change their strategy and improve their own situation; with the core nations deciding between cost-sharing and no cost-sharing and the periphery deciding between accepting more austerity or rejecting it. Credit Suisse has done an excellent job at representing this 'game' by recognizing that it boils down to costs and incentives. As they note, the continued existence of the Euro will hugely depend on the incentive structure of its members to defend it (and implicitly this means costs and retaliations - downsides - must be appreciated and allocated). These incentives evolve through time (and interventions can have unintended consequences) and brinksmanship and threats (Greece's referendum comments for instance) can improve outcomes in the short-term. Most importantly, it seems the market is among the best mediators to 'fix' each player's action and outcome but each intervention reduces that effect, 'time becomes money' as costs are increasing through procrastination. This leaves the asymmetric interests of the players (remember how exposed the core is to the periphery?) likely to increase break-up risks with Credit Suisse seeing the logical and intended consequence 'an increase in stress' - with either a 'catastrophic' break-up (or member exit) or a long, painful and volatile continuation of the crisis that can only be slowly improved by some type of inter-European enforceable contract.


Credit Suisse: A Nash equilibrium for the euro – It’s all about incentives

Existence of several parties, whose interdependent and incentive driven actions determine the outcome means Game Theory is the right tool

Game Theory has already been a valuable tool to analyse Greek PSI

The continued existence of the euro will hugely depend on the incentive structure of its members to defend it. In order to do so, costs must be appreciated and allocated

Players must consider:


  • Incentives to deal with these costs are aligned only under certain conditions;
  • An imbalance of incentives could lead to a euro break-up;
  • Incentives evolve through time and interventions;
  • Brinkmanship and threats are used as tools to improve either party’s outcome;
  • Market stress is a logical and intended consequence; and
  • Markets can be used as a mediator to improve each player’s outcome.


Single step game

Two players: Core and periphery

Potential COST allocation:

  • Core: Inflation, bank rescues and wind-downs and debt mutualisation
  • Periphery: Increased austerity, labour market reform and privatisations
  • Time is money: costs are rising through procrastination

Game of “Chicken”with 3 Nash equilibria, 2 pure and one mixed strategy

Asymmetric interests increase break-up risks


Game evolution

Brinkmanship and threats as tactics to improve one’s individual situation

  • Brinkmanship is a tactic by one player that is intended to minimise the possibility of the other player choosing an aggressive strategy
  • Threat of irrational behaviour: counter the aggressive strategy by the other player with one’s own
  • Necessary condition for success: threat needs to be credible
  • Example: Merkozy’s reaction to Papandreou’s referendum

Multi step game

The euro crisis is an evolving, multi-step, i.e. repeat game

Relationships and potential for retaliation are very important. For example:

  • Credible austerity measures could be “rewarded” by the core
  • Austerity fatigue would result in lower fear of a euro break-up in the periphery

Logical and intended consequence: Increase in stress


The point being that we will continue to swing from extreme stress (Q3 2011 sovereign debt contagion realization) to little stress (January perhaps on the back of LTRO) and back to extreme stress (March perhaps if PSI fails or Greek measures are not met)  and the un-intervened market is a key mediator in that reversion process.

Future scenarios

  1. A (catastrophic) break-up or (very expensive, probably catastrophic) exit of at least one large member. Possible but not likely (10%-20% probability)
  2. A long, painful and volatile continuation of the crisis that can only be slowly improved by some type of inter-European enforceable contract

The more intervention, the lower the consequence and the higher the volatility in the system before threats are taken seriously (or consequences admitted).

Perhaps yesterday's discussion of this pent-up volatility ready to flare is worth another look?

We have lived through a long period of financial management, in which failing financial institutions have been propped up by emergency intervention (applied somewhat selectively). Defaults have not been permitted. The result has been a tremendous build-up of paper ripe for burning. Had the fires of default been allowed to burn freely in the past we may well have healthier financial institutions. Instead we find our banks loaded up with all kinds of flammable paper products; their basements stuffed with barrels of black powder. Trails of black powder run from bank to bank, and it's raining matches.

Perhaps somewhat ironically, therefore, until we get another risk flare (Italy/Spain/European financial credit), there will be no endgame in Europe (positive-endgame) since incentives become negligible.

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francis_sawyer's picture

"We can control the horizontal... We can control the vertical..."

slaughterer's picture

Operation robo-kill phase 1 continuing nicely today.... (In best Montgomery Burns voice).

CvlDobd's picture

My perma bull colleagues are not shaking in their boots over 20 Dow points.

I hope you're right and it shows up though.

Black Friday's picture

It's always the diagonal that gets you.

sangell's picture

With each bailout risk is being transferred from PSI to OSI. First default on official lenders will be the last because the IMF, ECB and AAA nations will not fund anymore bailouts if they are going to be left holding the bag!

ACP's picture

All those charts and graphs and stuff...

...that's why false flags were invented.

Dick Darlington's picture

OT: Venizelos begging greek citizens to put their money back into greek banks saying they are perfectly safe. It was revealed today one of the MP's pulled out 1 million out of the country.True political leadership...

Spigot's picture

The T-Shirt ad says it all: "In case Zombies chase us, I am tripping you."

Nothing on the news wires has anything to do with what TPTB are really doing/planning. Its all disinformation.

The whole PIIGS tragi-comedy is about power and control pure and simple.

smb12321's picture

When default was first discarded, the die was cast and all actions since then are simply variations on a theme.  It is now seen as normal that central banks print trillions, distribute them to institutions who can take risks without risk.   We are riding an ever-growing wave of phony money that will - at some point - reach land.

slewie the pi-rat's picture

gee, i hope the SWISS can figure out what THEY will do, supporting the EUR and all, when, not if, germany tells everone else involved to go pound salt?

maybe they could get china to recapitalize their complete nonsense?

Motorhead's picture

Charts and tables, bitchez!

Taint Boil's picture



At least the sine wave looks better than the Google's Doodle for the day [they got it wrong].

steve from virginia's picture


The article's precept is incorrect. There is no 'sorry, I won't accept austerity' choice. Austerity is unavoidable in Greece and the rest of Europe. All except Norway and Denmark are energy debtors that must borrow -- externally because of the euro -- in order to obtain fuel.

Eurolandia blows through four billion (borrowed) euros a week to keep its auto circus jumping through hoops ... no wonder the Continent is bankrupt!

Eurolandia cannot pay, its fuel use has returned absolutely nothing over the course of decades. What is underway is the crawling up the masts on a sinking ship. The rat Germany is right now on the tallest mast but the ship is going down and all the rats will drown.

All the rats, all of them. This includes the US rat and the China rat.

There is no game 'theory' involved, rather it is the 'running out' fact. The world is running out of needed resources. Those remaining cost too much to waste. The Greeks and the other weak states are being excluded from the energy supply. Unfortunately, the strong states depend on the energy supply as much or more than do the weak ones.

Could be much worse for Greece, the EU could have decided to treat it like Libya.


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