Virtually all developments in Europe over the past two years can be easily explained using a simple version of three actor game theory. So can the endless delays in reaching an actionable resolution. The problem, however, as Bill Gross earlier, and now Bank of America, shows, is that the incentive to delay, based at least on one the actors' preferences - that of the market - is becoming very tenuous, and "the risk of an ugly end game is rising." By implication, this means that the goodwill of both Europe's monetary and political authorities is waning by the day, as last Thursday demonstrated so very vividly.
Bank of America explains.
The game tree: In a simplified game involving three players – a peripheral country called “Grain,” the other EU economies, and the markets – and three possible outcomes – crisis averted, bailout or default by Grain. Our work explains why Europe has been muddling through for so long and why the risk of an ugly end game is rising. The sequence of decisions is as follows: first, Grain undertakes some austerity measures. The markets then deem these actions as credible in moving toward a sustainable fiscal path, or not. If not, pressure on Grainish debt builds to a breaking point and the core EU countries decide if they will bail out Grain or leave it to default. Keep in mind that by Grain we mean not only the Grainish government, but all of the internal players that dictate whether an austerity program works. Solving this game requires ranking the relative attractiveness of each outcome. Keep in mind the motives and perceptions of the players. These are politicians, not economists. A default by a Euro area member is the worst outcome for everyone because the ensuing recession would drive many incumbent politicians out of office. So we assumed that Grain would favor a bailout first, austerity second and default third; the EU would favor austerity first, bailout second and default third; and, for the markets, we assume speculative pressure dominates, so the market prefers default first, austerity second and bailout third.
[7]