Greece and the Troika's 'Grexit' Game Theory

JUN 4, 2015

Forbes

Jon Hartley

CONTRIBUTOR

Following the recent tragic death of the famous mathematician John F. Nash Jr., known for his 2001 biopic, “A Beautiful Mind”, it’s incredibly interesting how much his game theory concepts can describe and make predictions about Greece’s decision to reach a new agreement on bailout terms by Friday’s deadline and whether the rest of Europe would eject Greece from their currency union.

The Nash equilibrium, named after Nash who proved its ubiquitous existence in his 28-page Nobel-prize winning 1951 Ph.D. thesis, was a revolutionary concept that essentially a way to predict the outcome of events in matters of conflict and non-cooperation much like between Greece and Europe in their present stand-off.

Using this type of analysis can help us understand better why a “Grexit” is a non-credible threat and what is known to game theorists as a “strictly dominated strategy”. Game theory can also help us to understand how the ongoing Greek bank run could be quelled by European policymakers signaling that a “Grexit” is out of the cards, dispelling asymmetric information in what’s known to game theorists as a “Bayesian game”.

Why a “Grexit” is strictly dominated strategy for Greece and the rest of Europe

To understand how the “game” works and identify the Nash equilibrium (the predicted outcome), one must first understand the incentives of all players, namely those of Greece and the rest of Europe. One key question to ask is what makes this default stand-off difference from previous Greek defaults in the past few years? In 2010, Eurozone leaders had written-off close to 50% of Greek debt and later signed off further parts of the debt to help Greece get its finances back on track.

The fact is this instance of default would not be much different than past write-downs, which saw little consequences other than tenuously agreeing to bailout terms involving austerity that were later renegotiated.

That’s because they’ve been repeatedly playing essentially the same kind of “game” with essentially the same set of incentives for both Greece and the rest of Europe.

With respect to Europe’s decision on whether or not to kick Greece out of the euro, Europe has no incentive to risk the contagion to financial markets that could follow such a move that would force a default on all the remaining Greek debt, beyond what is due in Friday’s interest payment to creditors.

Keeping Greece in the euro is optimal regardless of whether Greece defaults or comes to a new bailout agreement on Friday. Game theorists would call a “Grexit” a “strictly dominated strategy”.

European finance ministers have made this clear. French finance minister Michel Sapin said last Friday that “There is no Grexit scenario” after a meeting of finance chiefs from the Group of Seven industrial nations in Dresden, Germany.

German finance minister Wolfgang Schauble has previous struck different tone in negotiations, threatening that a Greek exit would be “manageable”.

This however is what game theorists would refer to as a “non-credible threat”, since Germany, according to economic theory, will ultimately act in its own economic interest to prevent financial contagion that would spread to the rest of Europe following a “Grexit”, namely to continental Europe’s financial capital Frankfurt.

Indeed, following this logic, Angela Merkel is said to be unwilling to consider the idea of a “Grexit”, sparking a contrast with the finance minister, according to German newspaper Die Welt.

For these reasons, such a ‘Grexit’ would be an unlikely event, even after another Greek default. While many countries default on their debt and repeatedly do so, few countries in default adopt new currencies, particularly due to inflation expectations that could erupt from an indebted country in control of printing money. In the case of Greece, exiting the euro would enable them to do so with their own currency.

A new Greek drachma would almost certainly create heightened inflation concerns, and is one reason why Greece has an incentive to keep the euro. Indeed, recent pools from Oxford Economics indicate there is a majority of support for keeping the euro in Greece.

The real uncertainty is around another default and Greece’s incentives to accept a new bailout deal with further austerity measures

The real uncertain question for analysts is whether Greece will default on its 1.5 billion euro interest payment on Friday. This boils down to whether Greece has a greater incentive to default on its 1.5 billion euro payment to spare country from further austerity or avoid the risk of economic losses related another default from creating further distrust with international financial markets.

An important part of this calculus is that the Greek government knows fully well that a “Grexit” as a repercussion is highly unlikely as it would be highly against the rest of Europe’s economic interests to do so in political spite. As a former academic game theorist himself, Greek finance minister Yanis Varoufakis very likely understands this well.

As another factor in this decision, one important change from the 2010 Greek default is that Greece is now self-financing, in that its government spending can be fully financed by its tax revenue. In other words, the only reason why they would need further loans is to pay off their outstanding government debt.

Hypothetically, Greece would no longer need to borrow from the Troika if Greek government revenues and outlays were to remain the same, which at some level gives them more bargaining power in their debt talks. This is an important fiscal milestone for Greece given that it will likely continue to be frozen out of international capital markets, especially Greece defaults again on Friday.

Bank runs, Bayesian games, and signalling no “Grexit”

In the meantime, depositors have been withdrawing cash from Greek banks in droves, leading to what may very well cause a “bank run” out of concern of bank insolvency and financial panic.

Academic evidence from a famous 1983 paper by Douglas Diamond and Philip Dybig shows that bank runs are very much linked to asymmetric information about bank liquidity and fear over the availability of deposits. That’s why since the establishment of deposit insurance and the FDIC in the U.S., traditional banking runs have become nearly extinct in the U.S..

From a game theory perspective, this bank run scenario for Greece is where there is asymmetric information between Greek depositors and policymakers (the ECB and the Greek government) about Greece’s fate is known as a “Bayesian game”. One optimal strategy available to players is to send information to other players, commonly known as “signaling”.

University of Chicago economist John Cochrane channels this “signaling” argument, suggesting that “if both Greece and Europe were to credibly say that Greek government default will not mean leaving the euro that would also stop the [bank] run.” It certainly is counterproductive to this cause when IMF chief Christine Lagarde recently called a Greek exit “a possibility”.

Bank runs themselves can lead to widespread economic catastrophe from the 1929 financial crisis to the 2010 sovereign debt crisis. For this reason, we must hope that Greece and Europe makes a deal to avert a default by Friday (likely through an extension on Greece’s loan agreement, and a renegotiation of the terms of its bailout) to signal that there is good faith and that Greece will not exit the euro, even if it’s already a given that Greece is staying according to the game theory calculus.