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? [8]) 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
[9]
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
[10]
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
- A (catastrophic) break-up or (very expensive, probably catastrophic) exit of at least one large member. Possible but not likely (10%-20% probability)
- A long, painful and volatile continuation of the crisis that can only be slowly improved by some type of inter-European enforceable contract
[11]
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 [12] 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.