The events of this week have greatly increased fears of Grexit from the euro. Negotiations between the troika (the European Commission, the European Central Bank and the International Monetary Fund) and the Syriza government in Greece appear to have imploded despite fervent hopes that a last-minute solution would be found. If Grexit does in fact set off a slow-motion implosion of the broader European unification project, that would be a grave cost indeed. In this, the 100th year since the commencement of the First World War, it’s important that the participants in these negotiations think through the very long run implications of any current actions.
Yanis Varoufakis, the erstwhile Greek finance minister, is famously a student of game theory. Game theory studies strategic interactions between individuals or groups, and it’s instructive to think through some its frameworks to better understand the negotiations and to draw inferences from their recent collapse.
A standard concept in game theory is the ability to burn money as a signalling device about the firmness of one’s intentions. This concept is especially interesting in the context of issues of coordination between two players. The idea is that when one player in the game (think Germany) has the option to burn money, they have the ability to alter the payoff structures for themselves in such a way that they have very few profitable options remaining. This means that with money to burn, Germany can essentially commit to following a narrower subset of all of the possible courses of action open to them.
If Germany has the option to burn enough money, they can put themselves in a position in which the only better outcome involves the cooperation of the other player (Greece) in the game. The reasoning goes that if all players are rational, Greece will realize that the very option to burn money has strongly limited the set of choices for Germany even if Germany doesn’t in fact choose to burn the money. Knowing this, Greece should choose the course of action that Germany wishes, even if it implies a less-desirable outcome than the Greeks’ hoped-for best outcome.
The reason for this rather technical discussion is that this is one possible model of the interaction between Germany and Greece. Or at least it was, until the events of the last two weeks. If we were in a world well described by the game described above, Greece should have known that deep-pocketed Germany is better able to face the costs of Greek capital controls, ensuing delays in debt repayment, or even the increased probability of Grexit and potential implications for the euro zone project than almost any other player out there. In other words, Germany has quite the pile of money to burn. The resulting understanding of payoffs, the reasoning goes, should have resulted in Greece simply folding, i.e., simply accepting all conditions imposed by the troika.
Clearly this has not happened. So what are we to make of this? A simple solution is to just write players off as being irrational. Deeper thinking is required—some inferences can be drawn from the behaviour of the players about their payoffs, constraints, and motivations without jumping to such conclusions.
The first inference is that structural adjustment and especially pension reform appear to be far more costly in the Greek economy than the troika have anticipated. Greek defiance may not simply be a bargaining position—we might infer that this behaviour is the result of real underlying political and economic difficulties in making changes to entitlements and pensions in Greece. In this sense, the referendum was a very clever move by the Syriza government to increase its own credibility—it is extremely difficult to interpret 61% of the Greek population voting no to the troika’s plan as a strategic move or a negotiating tactic.
These inferences about Greek constraints are augmented by Alex Tsipras’ move to sack Varoufakis, who was remarkably unpopular with the troika’s negotiating team. Greece appears to be signalling its willingness to accept creditor demands as long as they are implementable, and a desire to return to the negotiating table.
On the other hand, while they continue to have money to burn, the Germans are starting to look increasingly unreasonable in these negotiations. This has implications for their voice in ongoing negotiations, especially when contrasted with that of the countries of southern Europe.
These countries, especially Italy, Spain, and Portugal, are on the frontlines—they will suffer greatly if the market concludes that euro zone exit is not an impossibility. It naturally follows that these countries should be banding together and pushing for more flexibility in creditor negotiations with Greece.
We’re already starting to see signs of this, with Italy’s Prime Minister Matteo Renzi reacting to the Greek vote, saying that the European Union also needs to reform itself and to put an emphasis on “values”, not just numbers or parameters. He has stated that, “...If we stay still, prisoners of rules and bureaucracy, Europe is finished...”
Let’s hope that these wise words signal the beginning of more flexibility demonstrated by the troika, and a return to the negotiating table.
Tarun Ramadorai is professor of financial economics at the Saïd Business School, University of Oxford, and a member of the Oxford-Man Institute of Quantitative Finance.
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