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Game Theory and The Potential Greek Bailout

On the forefront of international and economic news lies the debate regarding the Greece’s sovereign debt crisis and the growing need for international support. For years, the nation has built up tremendous debt partially due to worker-friendly labor laws and wage increases, along with generous entitlement programs. Economically the strongest nation in the European Union, Germany is strongly considering purchasing mass quantities of Greek sovereign debt to essentially bail out Greece from impending financial turmoil (10 year Greek treasuries currently yield around 60%). http://www.businessweek.com/magazine/europes-debt-crisis-has-become-a-german-identity-crisis-09212011.html. Germany’s potential decision to bail out Greece is far more than an act of kindness and solidarity – rather it has immense economic consequences for Germany, Greece, and the broader EU. Not only does Germany (and German banks) hold Greek bonds that are on the edge of default, but also the country would feel secondary and tertiary economic effects from a potential collapse of the Greek economy. Even more importantly, the decision not to bail out Greece could risk the collapse of the Euro, an event which would have a severe negative impact on all EU member states. (Additionally, the reversion back to individual currencies, a scenario in which a strong Germany currency relative to other nations would hurt the German exports is another significant issue / incentive).

The two parties and their potential actions make for an interesting application to Game Theory. In actuality, more parties and potential actions are at stake, but for simplicity’s sake we consider just the two nations. The game has 2 players, Greece and Germany. Both players choose between different actions. Germany faces two options: “agree to help purchase Greece’s sovereign debt; or hold fast and risk the collapse of the Euro.” Likewise, Greece has to choose between taking on severe austerity measures, entitlement reform, in an attempt to balance its budget, or not changing their social policies and essentially crying for help.

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While it is difficult to assign values to potential outcomes, I assign arbitrary numbers to prove a point. If Greece chooses budget cuts, Germany is indifferent. If Greece chooses to cry for help, Germany will come to the rescue to avoid the potential meltdown. If Germany chooses to bailout Greece, Greece will avoid budget cuts and just take the aid from Germany.  If Germany chooses no action, Greece will make all budget cuts necessary to avoid the default. Thus, the Nash equilibrium in this case is (Cry for help, Bailout). This equilibrium is not a societally beneficial outcome as it yields a net of -5.

The societally best outcome, represented by the addition of the two payoffs, is Greece choosing to balance the budget and Germany choosing to bail out Greece. This outcome is most socially beneficial for a few reasons. Primarily, it avoids the default and the potential collapse of the Euro. While Germany spends money to buy Greek debt, Germans (and other nations around the world) need not worry about their investments defaulting. Additionally, Greece choosing NOT to balance the budget and thus continuing along the unsustainable path of deficit growth to provide entitlements will lead to even poorer credit ratings and another liquidity crisis – few individuals, corporations, or nations will want to lend money to Greece if it continues to rack up massive deficits. Mathematically, the payoff of (Budget Cuts, Bailout) is the best outcome at (0,0).

However, this optimal outcome will not occur unless the two parties coordinate on their strategies. Indeed, this collusion is what is currently taking place. German president Angela Merkel insists she will only move forward with the bailout if it is met with significant austerity measures taken from the Greek government.

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