Silvia Quandt & Cie. AG, Merchant & Investment Banking: In-between the lines - Bernhard Eschweiler
DGAP-News: Silvia Quandt & Cie. AG, Merchant & Investment Banking / Schlagwort(e): Sonstiges/Sonstiges Silvia Quandt & Cie. AG, Merchant & Investment Banking: In-between the lines - Bernhard Eschweiler
22.09.2011 / 16:50
- Euro debt crisis is escalating and may soon reach a climax
- Euro survival and no short-term defaults are the rational outcomes
- But risk of policy slippage is rising
- Some good news from Ireland
The Euro debt crisis is escalating in many ways. One focal point is Greece and its negotiations with the Troika over the payment of the next tranche of the rescue package. A broader and more severe issue is the rapidly deteriorating situation of European banks. There is a growing sense that only a big move can save the Euro. The worry is that politics is not able to deliver because of a lack of will and understanding as well as the complexities of the political process inside the EU and individual countries. Game theory is a helpful tool to analyze the situation and potential outcomes.
Not a prisoners' dilemma
Specifically, game theory can be applied to the decision of individual countries to stay in the Euro. The Euro treaty excludes the possibility that a member can be expelled, but individual countries can decide to exit. In particular, very weak countries like Greece or very strong countries like Germany may decide that they are better off outside the Euro. Of course, if Germany decides to leave, the Euro is finished. The same is not automatically true if Greece were to leave. However, a Greek exit could trigger financial, economic and political domino effects that could result in several members leaving and threaten the Euro as a whole.
Thus, the Euro has the best chance of survival if all members remain and cooperate. The textbook game in which the players fail to cooperate is the prisoners' dilemma (http://pespmc1.vub.ac.be/PRISDIL.html). So, does the Euro suffer from the prisoners' dilemma syndrome? The failure of politics to agree on a solution would suggest so. Still, no matter how bugged down
the situation may appear, two key features of the prisoners'
dilemma are not in place. First, unlike in the prisoners' dilemma, the Euro members meet and have the ability to negotiate agreements. Second, the incentives for each country are such that no matter what the others do it is always better off to stay in the Euro (see box). For Germany, the cost is not just economic. Unilateral exit would bring down the Euro and isolate Germany in Europe as well as globally. For Greece, the only reason to leave would be if the other Euro members would offer it sufficient financial compensation. In isolation, that may not be so costly for the rest of the Euro group, given Greece's small size. However, it would create an incentive for other weak Euro members to demand the same treatment and, thus, threaten the Euro as a whole.
A weak country leaving the Euro will trigger default. However, staying in the Euro is no protection against default. Greece, for example, could decide to default or the other Euro members could trigger default by not supporting Greece. Important is also to distinguish between disorderly default and orderly (cooperative) restructuring. Greece surprising with a unilateral default is unlikely to please the other Euro members and risks the withdraw of financial support. The result would be as catastrophic as
leaving the Euro. Thus, Greece has a strong incentive to cooperate. For the other Euro members, the restructuring of Greek debt is a matter of timing and not principle. Greece is insolvent. However, restructuring the
debt now could trigger a domino effect that involves more countries and threatens overall financial stability. Second, early restructuring removes the pressure for Greece to undergo the necessary fiscal and structural reforms and creates a precedent for other weak Euro members to follow. Thus, the other Euro members have an incentive to prevent a Greek default until market conditions are calmer and Greece has made enough reform progress. Most likely, that time will coincide with the Troika holding the majority if not all of Greece's debt.
The risk of cheating and trembling hands
So what can go wrong if the game is so clear? Two things: First,
so-called cooperative games are vulnerable to cheating; Second, rational (incentive compatible) outcomes may not be reached because of mistakes, the so-called trembling hand syndrome.
- After working out a deal with the Euro group, Greece has an incentive to cheat. The cheating may come more in the form of feet dragging and negligence, but the cancelation of its visit to Greece shows that the Troika was not pleased. The problem is that the Euro group has too much at stake for just letting Greece default. - The risk of trembling hands is mostly political. For example, the Greek government toying with the idea to conduct a referendum to gain more support for its policies could backfire. Another example is the disagreement within the German government and parliament. Minority players with different agendas could prevent making the right decisions.
Moving from the game back to reality, the next few weeks promise to be tense. By the time the German parliament ratifies the decisions of the EU summit, the market will say 'thank you and now please double up'. The resulting tensions could split the already fragile German coalition government. This may lead to the formation of a new coalition or early elections. No matter what, uncertainty will rise and swift decisions will be less likely. Eurobonds will probably come back on the agenda, but the sheer complexity of required constitutional changes in Germany and all other Euro/EU members will make their implementation close to impossible. More likely is a significant increase of EFSF funds and some form of mandatory bank recapitalization combined with ongoing bond market interventions by ECB and possibly EFSF.
The grass in Ireland is greener
The deleveraging that much of the Euro area has to undergo is unlikely to be achieved through nominal adjustments (devaluations and inflation). Even if the ECB would follow Fed, BoE and BoJ and engage in large-scale quantitative easing, the banking system is too impaired to pass the money. Instead, the adjustment will have to be real. That means in particular restoring competitiveness. Ireland still has much to do to consolidate its public sector, but it has made huge progress in terms of restoring competitiveness (largely through unit labor cost reductions). The progress is visible in the current account turnaround and the drop in bond spreads (from over 1100 bps over 10-year German Bunds to under 700 bps).
Disclaimer
This analysis was prepared by Bernhard Eschweiler, Senior Economic Advisor, and was first published 22 September 2011, Silvia Quandt Research GmbH, Grüneburgweg 18, 60322 Frankfurt is responsible for its preparation. German Regulatory Authority: Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), Graurheindorfer Str. 108, 53117 Bonn and Lurgiallee 12, 60439 Frankfurt.
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