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The Greek and German dilemma

Europe’s leaders are facing dilemmas on what to do with the struggling euro zone and a Greek’s possible abandonment of euro zone’s membership. Even a single exit from the euro zone can cause an implosion within the zone, exacerbating the current instability of the euro. An exit would bring chaos to the entire euro zone, for it would start ‘a chain reaction,’ as policy makers stated. A possible Greek exit has already contributed to higher borrowing costs for Spain and Italy and a higher barrier for Ireland and Portugal to return to market funding. Furthermore, its exit would possibly drive Italy and Spain to “[lose] market access and [require] even more financial support from the euro zone core,” the U.S. economist Nouriel Roubini suggests.

Ultimately, the decision of the membership, whether it be Greece’s or other members’ of the euro zone, will significantly affect its partners’ decision and their economic stability. Game theory can explain why some countries are interested in giving up the membership or stay put in the euro zone. It can also explain why some countries choose or choose not to implement certain programs or issue bonds. The theory states that a collection of individuals that commit to a certain strategy receives a payoff that depends on the strategies chosen by everyone. Individuals may seek a way to gain the most without making a sacrifice, resulting in their not trusting one another to cooperate for a better outcome. In fact, this case closely resembles prisoner’s dilemma in which each prisoner chooses a dominant strategy and a resulting outcome is worse for both of them.

Foreign exchange strategists at Bank of America Merrill Lynch stated that both Germany and Greece would benefit if Greece carried out its austerity program and Germany issues bonds backed by the credit of the Euro zone. However, neither is likely to choose such option, because they will be better off without making such sacrifice. If we look at the hypothetical table below, we can understand why this happens.

(a,b) = (Germany, Greece)

Germany(col)  /  Greece(row) Austerity program(&take risks) No austerity program
Issue bonds(&make a sacrifice) (7,7) (2,10)
Not issue bonds (10,2) (5,5)

Suppose that Germany has two options: issuing bonds and not issuing them and that Greece has two options: carrying out austerity program and not carrying it out. Both can choose one of the two options they have, and the numerical outcomes of their decisions represent their gains. (These outcomes may be far from reality; I assumed that the numbers represent the reality to show why the two countries make certain decisions.)

Suppose again that Germany chooses to issue bonds. Greece will be better off if it chooses to not carry out austerity program, because it will gain 10 instead of 7 by doing so. The program is beneficial; yet, it may be counter-productive in that it may increase unemployment and decrease GDP. Therefore, the value of not having austerity program for Greece is higher than implementing the program.

If Germany chooses not to issue bonds, Greece, again, will be better off if it chooses to not carry out the austerity program. In this case, Greece does not have to take any risk involved with the program.

Germany is in a similar situation. If Greece chooses to carry out austerity program, Germany will be better off by 3 (10 minus 7) if it chooses not to issue bonds. The value of issuing bonds is smaller than that of not issuing bonds, because the bonds are backed by the Euro zone’s credit. And if Greece chooses not to carry out the program, then Germany again chooses not to issue bonds, because Germany will gain 5 instead of 2 by doing so.

The dominant strategy for both countries is, therefore, (not issue bonds, no austerity program)=(5,5). However, there are responses that leads to a better outcome for both of them, which is (issue bonds, austerity program)=(7,7). They know that the later outcome is better for both of them, but under rational play of the game, there is no way for Germany and Greece to achieve this outcome. Instead, they end up with an outcome (5,5) that is worse for both. In other words, Germany and Greece could have contributed to a more stable economy by choosing the strategy (issue bonds, austerity program)=(7,7), but they end up having a less desirable outcome.



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September 2012