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Game Theory in the Greek Default

Howon Song

Hs459

9/23/11

Reference: http://en.rian.ru/analysis/20110913/166819595.html

As the world economy is at red alert, the most apparent economic danger persists in Greece. For quite a long time, European leaders have been discussing the best possible solutions for the stubborn economic depression over the European region. However, most economists and political experts are now assuming an imminent default of Greece; the country lacks potential drivers (almost to an extent of non-existent) and is burdened with high debt, costs, and excessive employment. Although in the past European countries have been trying to share the burden together, they are now considering whether it is more beneficial to let Greece default. The linked article, Greek default, new crisis essential for Europe’s economic recovery argues that Greek default is a necessary evil for both Europe and Greece to revive from the current economic condition, and achieve the most mutual benefit.

The article argues that Greek default is a logical step to take under current circumstances. The 110 billion euro loan that IMF and EFSF provided last May and the strong reforms that Greece have gone through still have not appeased the Greek economy. While Greece stepping out of the Eurozone had been considered taboo in the past, now European leaders are already preparing for the scenario in which Greece disintegrates from the EU. German government has prepared an urgent bailout plan in order to prepare for the case where financial institutions fail, suddenly after the possible Greek default. On the contrary, the Greek default could actually mean a disaster in entire Europe, as it could trigger the domino failures of European countries with heavy debts such as Italy, Portugal, Spain, and Ireland. The failure of financial bonds of multiple European countries would be disastrous to not only Europe but also the world.

To relate this catastrophic economic crisis to simple game theory models that we learned in class, I thought it would be interesting to set two of heavily-debt European countries (Italy and Ireland) as two players of the game. The two choices for each player would be then whether to financially support Greece to prevent or at least delay the Greek default.

Ireland

Italy

Support Not Support
Support (10,10) (-10,0)
Not Support (0,-10) (-10,-10)

The game in real practice is undoubtedly complicated so there are many assumptions held in the above table to make things simpler; we are only assuming short-term financial benefits and consequences following after the decisions, ignoring all the long-term political effects. Also we assume that both countries have to support Greece at the same time to favorably affect the Greek default. When only one country supports, the one that supported loses because it would not make difference to the Greek economy without the other’s help; the supporter only lost its valuable money. When both countries decide not to support, they both lose because it would accelerate the Greek default as well as the breakdown of their own financial institutions, including trustees bonds. The best option for the game is when both countries support Greece; this is a strictly dominant strategy as it brings the biggest mutual benefit. When both countries decide to aid Greece at the same time, we assume that it will favorably affect the Greek economy and may delay or prevent the Greek default.

Of course in real applications, such game theory is almost useless with the set of unrealistically simple assumptions. However, it gives insight into how game theory might be useful to predict the possible decisions of different European countries, especially when their advantages and consequences heavily depend on their choices. It is interesting to acknowledge that this simple technique that we learned in class can be implemented in such complex problem.

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