Greece and The Greek Games by Bill O’Grady of Confluence Investment Management
(Due to the President’s Day Holiday, the next report will be published Feb. 23rd.)
After the Syriza party won 149 of the 300 seats in the Jan. 24th Greek elections, European markets have been roiled by worries over another crisis developing. The party has engaged in some provocative behaviors; its leader and Greece’s new prime minister, Alexis Tsipras, decided that his first official visit would be to a monument that honored Greek citizens who suffered a mass execution at the hands of the Nazis. That symbolism wasn’t lost on anyone. Tsipras, and his new finance minister, Yanis Varoufakis, have indicated
that they have no interest in fulfilling the bailout requirements of the European Central Bank (ECB), the European Union (EU) and the International Monetary Fund (IMF), the “troika” that has managed the bailout for Greece.
Austerity has severely harmed Greece’s economy, cutting its GDP by 26% from the pre-crisis peak. The unemployment rate is 26% and youth unemployment is over 50%. The election of Syriza is a reaction against the economic depression that Greece has endured as Syriza ran on an anti-austerity platform.
Of course, one nation’s austerity is another nation’s reform. The German position, which has become the establishment position in Europe,1 is that excessive Greek fiscal spending and borrowing is responsible for the problems in Greece. This excessive spending and borrowing is seen as leading to rampant corruption, gold-plated salaries and benefits for government employees and economic inefficiency. Only reforms, or austerity, can bring Greece any hope of recovery.
The Greek and anti-establishment position is that Germany is the cause of not just Greece’s economic collapse, but the economic crisis in the Eurozone periphery.
This chart shows German exports as a percent of GDP. Prior to reunification, exports generally represented around 23% of German GDP.
Exports rose as the German government changed policy following reunification and have moved steadily higher since the euro was formally introduced in 2000, now representing over 45% of Germany’s GDP.
Germany engaged in policies after reunification that were designed to reduce labor costs, improve productivity and build saving. These policies made the German economy overly dependent on exports that were mostly sold within the Eurozone, which for Germany is a single-currency free trade zone.
In order to sell these exports to the rest of Europe, German banks engaged in a sort of “vendor finance,” where German banks and investors bought the debt from the periphery who then purchased German exports. Of course, this problem was exacerbated by the use of a common currency and the perception among investors that the bonds of individual countries in the Eurozone were, somehow, mutualized. In other words, no country would default because the Eurozone was unified. Thus, borrowing costs fell to northern European levels in the periphery which spurred even more consumption in the southern regions of the Eurozone. Of course, we now know the debts were not mutualized and that the Eurozone has serious unresolved issues.
In this report, we are going to use game theory to describe the situation between Greece and the EU/Germany/ECB. This method shows how misunderstandings can develop and how catastrophic mistakes are made. Using this structure, we will outline the positions and perceptions of both sides and describe how this situation could lead to another crisis. As always, we will finish with market ramifications.
Game Theory was developed after WWII and was used by analysts to predict behaviors between a limited number of players. In economics, it is often used to describe the interplay between firms in an oligopoly. In defense analysis, it was used heavily to create the rules of the road between the U.S. and the U.S.S.R. The concept of “mutually assured destruction,” or MAD, came out of game theory.
The canonical game in Game Theory is Prisoner’s Dilemma. It describes a situation in which two players, acting in a rational fashion, end up with a less than optimal outcome.2
Game theorists have created iterative tournaments to observe how players behave in multiple rounds. A number of interesting outcomes have developed; in general, the best strategy is “tit-for-tat,” which is to be quiet until someone rats then always rat with that particular player. They have also noticed that “nice” players tend to congregate with each other and group-punish defectors. In a single play without collusion, we expect the Rat/Rat outcome. In economics, when that outcome isn’t observed, regulators often fear that collusion has occurred which often leads to antitrust violations under U.S. law. At the same time, prisoner’s dilemma undermines the idea that economic actors, operating under conditions of self-interest, will always arrive at the most optimal solution. The prisoner’s dilemma game suggests that under conditions of imperfect competition, a less than optimal outcome is likely if participants follow self-interested behaviors.
Another canonical game is chicken.3
If both veer, both suffer some loss of face. If one veers and the other doesn’t, the holding player wins. If both hold, they suffer severe damage.
This game assumes that the losses are symmetric. The MAD concept assumes a game of chicken, in which Veer becomes No Attack and Hold becomes Attack. If both attack, the world ends. If the losses become asymmetric, then one of the players who perceives that his relative loss is less may consider a hold position. That is why, in MAD, treaties were put in place to prevent the creation of missile defense systems for fear it would make one of the parties believe that their losses in an Attack/Attack outcome would be survivable and thus encourage war. As long as both parties believe that complete destruction is the most likely result, neither would attack. In effect, if both players can create rituals that minimize the costs of “loss of face,” a chicken game can be repeated.
Greece, the EU/Germany/ECB and Chicken
We believe that Greece and the Eurozone are effectively engaged in a game of chicken. However, Alexis Tsipras has concluded that the payoffs are more favorable to Greece than those of his predecessors, and so he is willing to risk a financial crisis to get the troika to Veer. The establishment is equally worried that Tsipras has underestimated the dire straits his nation is in and is at risk of triggering a crisis that may lead to Greece’s exit from the Eurozone.
Syriza’s Positions and Issues:
- The party believes that the German economy is so dependent upon the Eurozone for its export-driven economy that it cannot risk anything that would lead to a breakup of the single-currency bloc.
- It also believes that the exit of Greece from the Eurozone would set off the exodus of other nations and bring into question the entire European unification project that began in the 1950s with the European Coal and Steel Community. A breakdown of this order would trigger fears that Europe is heading into a period of rising nationalism that was responsible for two world wars in the last century.
- Syriza believes that an ECB cutoff of liquidity from its banking system would trigger bank runs in the periphery nations