Greece, Europe and the Rest of the World
European governments have been struggling with how to deal with the Greece debt crisis. They have many options to consider both short term, long term, financially, and politically, which makes there decisions very complex, but they can still be analyzed using game theory. To simplify the analysis of this game, I’ll use only two players, Greece and Europe(this will include all countries and entities in negotiations with Greece). Each player has two main options, either to negotiate and form some kind of deal or to not make a deal. Each side has many considerations in whether to reach an agreement.
I’ll start with Greece, in order to reach an agreement and not be forced to default, Greece must accept some level of austerity measures to instill confidence, and offer high interest rates on new longer term bonds to lure investors to accept the high risk. Both of these things are negative outcomes for Greece, they make it difficult on the people of Greece and the higher interest rates actually increase the debt burden while shifting it further into the future. This also has negative effects on the politicians who accept the deal as most Greeks do not approve of the austerity measures. So negotiating allows Greece to obtain loans, to fund current debts, as well as allows them to obtain concessions from private investors to take a reduction in Greek bonds, reducing the value of Greece’s debt. The outcome of this is very negative for Greece but it prevents a default. The second option for Greece is to not negotiate. This will most likely cause Greece to default as they will not be able to keep ahead of their debt as it comes due. A default would mostly likely cause Greece to be forced out of the Eurozone, which would allow them to devalue their currency, but would probably cause a run on their banks, and would severely weaken their economy(at least in the short run), and it would probably take years to come back from. This however, doesn’t force austerity measures on the Greek public, but the weakened economy would likely have many effects similar to those taken through austerity measures. This option is also very negative for Greece.
Now looking at Europe, they have the same options, negotiate, or don’t negotiate. If they decide not to negotiate, then Greece will be forced to default as there is no one else who could support Greece. If this happens, the Euro will most likely weaken, and any banks and governments holding Greek debt would lose tremendous value. This loss from Greek debt could cause a new banking crisis in the rest of Europe and could cause other weak economies like Italy, Spain, and Portugal to weaken and follow Greece in default. This option is very negative for Europe, the only benefit of not negotiating is short term political gain, by not offering up other countries capital to finance the excesses of Greece. The stronger countries like public of the stronger countries (like Germany and France) do not want to spend their hard earned money on Greece, especially when the economy around Europe and the globe is struggling. The other option for Europe is to negotiate with Greece, to offer up loans and capital from their own governments, banks, and other enities(IMF, ECB, etc.) to help Greece finance its debt, and to accept a loss of value on privately held Greek bonds in exchange for austerity measures and interest from Greece. These austerity measures and interest should ensure that Greece is able to lift itself out of its current debt crisis and be able to repay these loans. This however comes with negative political incentives, and the public of the countries of Europe do not want to finance the troubles of other countries. Based on these choices, Europe’s dominant strategy regardless of what Greece decides is to negotiate to reach an agreement. This minimizes Europe’s losses. This leads to a matrix with the smallest loss for both sides negotiating to reach an agreement, and the other 3 options with the same larger loss, and regardless of who decides not to negotiate the outcome will be the same.
Although, this use of game theory suggests that both sides will negotiate and so far both sides have been, but very slowly, and in this climate the more time the take to reach an agreement the worse off both sides are. However, even with the strong incentives to reach an agreement, and even after reaching an agreement last week that had a loss in value of 50% on privately held Greek bonds, Greece has shaken things up and scared Europe and the rest of the world, by calling for a referendum on the agreement. This was done due to the strong political pressure from the people for accepting more austerity measures after all of the measures already taken. Based on this game theory the referendum should pass, however the referendum has different players, it is not the two negotiating parties, but the individuals of Greece and they have different incentives than the negotiating parties, which is why financial markets have gone down. There is fear that the incentives for the individuals will be to vote against the agreement.
A failure of the agreement would cause the financial strain in the rest of Europe and most likely in the rest of the world as well. This fear is expressed in the stock markets by their dropping in prices. This occurs when the ask prices drop, due to people wanting to leave the stock market and invest their money in something they think might be safer such as US treasuries.
http://www.bbc.co.uk/news/business-15533940
http://online.wsj.com/article/BT-CO-20111101-710738.html