Friday, 17 February 2012

Russell Crowe’s Beautiful Mind Games

Image by Caroline Bonarde Ucci
Having spent the week presenting to clients, a recurring question has been “Can you explain how the current negotiations with Greece will be resolved - using a non-zero sum asymmetric game theory model?” To which I invariably replied “Of course! Although my rudimentary understanding of Game Theory is driven by having seen Russell Crowe in A Beautiful Mind ten years ago, I’m sure Wikipedia can fill any gaps in my knowledge.”

First we need to consider the ambitions of the two parties as they enter negotiations:

  1. The Grecian position is magnificently simple. They need to extract the funds to run their economy such as public sector wages, benefits and payments to suppliers. An economy can’t function if participants don’t believe the government will meet these costs. Greece though, remains in a situation of primary fiscal deficit (meaning that, even after ignoring the costs of servicing existing debts, tax revenues still won’t cover costs). The troika (the committee led by the EC, ECB and IMF), therefore, is their only path towards stability.

    The Greeks have the choice of either attempting to implement austerity or not doing so.

  1. The troika’s position is slightly more complex. It needs to minimise the financial cost of bailing out Greece and incentivise other struggling states to restore their finances without further aid.

    The troika has the option of either insisting Greece stick to the current deal or forgiving it of some or all of its debts.

The troika’s objectives don’t sound conflicting but further funding of Greece’s remaining debt pile (part of the deal currently being tabled) is a significant cost. This makes the alternative, reducing Greece’s debt burden further, more compelling than we might instinctively think.

With this in mind I have constructed a pay-off grid to reconcile the interests of the troika and Greek authorities. The first figure in each scenario is the pay-off for the troika, the second is the pay-off for Greece.















The status quo is not the best solution, it carries a high financial cost for the troika and a high social cost (even greater unemployment etc) for Greece. It is, however, superior to the disorderly default scenario in which the troika will have insisted upon Greece meeting the current programme but Greece will have defiantly reduced their austerity measures. As the worst outcome possible this would imply that Greece can no-longer fund its public sector, whilst the troika wrestles with the potential financial contagion of Greece’s unplanned default.

Orderly default is preferable to this – particularly for the Greeks but if other debtor nations see debts being waived for countries failing to meet austerity programmes, they will have a reduced incentive for complying themselves. The Troika would therefore not rationally accept this scenario.

Logically therefore the best path for both parties is that of conditional default as it reduces the amount paid by the troika, and makes the burden of austerity measures more manageable. This solution which represents the best deal available for each party, bearing in mind the views of their counterparts, is called the Nash Equilibrium, or for fans of A Beautiful Mind, the Crowe equilibrium.

Unfortunately this simplistic analysis does not go quite far enough. A whole second layer of interests are involved when we consider the motivations of the Greek opposition parties (who want to win political capital at the authorities’ expense) and the deviant interests of members of the troika (each of which represents a banking system with different levels of exposure to Greek debt).

As is so often the case, life is not as simple as Russell Crowe makes it seem.


GUY FOSTER

2 comments:

  1. Bailing out Greece is just another way of bailing out the banks. They should bear the responsibility for having bought Greek bonds.

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  2. If Greece is allowed to default Portugal will not be far behind. The Irosh will feel stupid for having take their pain!

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