John Nash's Game Theory and Greece

MAY 29, 2015 2:00 AM EDT

By Mohamed A. El-Erian

Bloomberg

Economics and finance suffered two tragedies in the past week: the death of the Nobel laureate John Nash and his wife in a horrible car accident, and more delays from Greece and its creditors in reaching an agreement on a path out of the costly and protracted crisis.

A mutually beneficial outcome would alleviate the long suffering of Greek citizens who have been devastated by unemployment, shrinking incomes and spreading poverty. It would also bolster the credibility, integrity and robustness of the euro zone as a viable economic, financial and political entity. And it would remove one of the uncertainties preventing the global economy from achieving a pace of growth consistent with its potential.

At first sight there seem to be little to link the two tragedies. Yet the game theory insights that John Nash pioneered -- including the concept of a "cooperative game" -- shed important light on what is happening in Greece, and help explain why the drama is unlikely to have a happy ending anytime soon.

In a cooperative game, players coordinate to achieve better outcomes than the ones that would likely prevail in the absence of such coordination. If the game is played uncooperatively, however, the result is unfortunate for all players.

This simple idea accurately describes the protracted Greek drama, including the current rush at the Group of Seven meeting in Germany to find yet another way to kick the can down the road.

At the simplest level of analysis, Greece is seeking to regain economic growth, create jobs and restore its financial viability, while remaining part of the single currency. Its European partners, working with the International Monetary Fund, share these goals, so long as achieving them doesn't impose a disproportionately heavy burden on other euro zone states in terms of finances and political acceptability, and by setting a poor example for future crises.

The problem, in game theory terms, is that a game that needs to be played cooperatively to achieve the desired outcome continues to be played uncooperatively -- repeatedly. The reasons for this unfortunate state of affairs are understandable:

 There is little trust between Greece and its creditors (in this case, the European Central Bank, the European Union, and the IMF).

 The sides haven't defined a common understanding of the problem, even less a solution.

 The process for ensuring that policy and financing commitments are met is patchy and often controversial, in part because of  political undertones: The Greek government doesn't want to be perceived as subservient to other European nations and those countries don't want be viewed as financial hostages to the inadequacy of Greek policies.

 And the functioning of the coalition of creditors (once known as the Troika) is far from smooth.

Thoughtful economists such as the Nobel laureate Michael Spence have extended this concept of a cooperative game being played uncooperatively to the broader dysfunctions influencing the global economy. This type of game points to costs that far exceed simply suboptimal outcomes; it also entails the possibility of collateral damage and unintended consequences.

There are at least four ways to transform uncooperative games into cooperative ones. Unfortunately, these approaches would be ineffective in the case of Greece.

One involves using two-sided and mutually supportive conditionality as the transformation agent: for example, by rewarding the implementation of economic reforms with the ready availability of external financing. This has been tried in Greece, but the results have fallen short, which has diminished the effectiveness of this tool. Specifically, Greece's record on making good on its policy-reform promises has been far from perfect; and its creditors have been too hesitant in providing the extent of debt relief and cash the country needs.

A second way involves a decisive external impetus. In the case of Greece and its creditors, this role has been played by fear, particularly the fear that the Greek economy would implode, which would force it out of the euro zone. This has stoked the additional fear that such an outcome would destabilize other euro zone economies, threaten the integrity of the single currency group and disrupt the global economy.

And fear is an inconsistent transformation agent because its impact is hard to sustain. As soon as it dissipates, all sides revert to uncooperative behavior. And this is what has happened in this case since at least 2010.

A third alternative involves the entry of new players that are willing and able to put aside uncooperative legacies. In today's Europe, however, the political reality is that new players tend to be even more skeptical than their predecessors. The electoral victory of Syriza in Greece is a case in point.

Finally, mutually beneficial developments could convince both sides to work together more closely. Regrettably, this hasn’t been the case of Greece and its European partners, given the limited progress on the ground.

Assessing the Greek drama through the lens of game theory explains why the crisis -- and the question of Greece's continued euro-zone membership -- are no closer to being resolved. Applying Nash's theory shows that the best we can realistically expect is yet another attempt to postpone painful decisions. But even this inadequate outcome is proving increasingly difficult to deliver, and if it materializes, the resulting delay will lead to an even more difficult situation, unless the players decide to stop their uncooperative game very soon.

To contact the author on this story:

Mohamed El-Erian at melerian@bloomberg.net

To contact the editor on this story:

Max Berley at mberley@bloomberg.net