Better in their words…

By Matthew Lynn

LONDON (MarketWatch 2/23/12) — What movie should you watch to try and understand the torturous progress of Europe’s debt crisis? “Zorba the Greek,” maybe? “The Never-Ending Story,” perhaps? In fact, the best thing you could slot into the DVD player would be ‘A Beautiful Mind’, Ron Howard’s well-crafted film about the mathematical genius John Nash.

The latest round of torturous negotiations between Greece and the rest of Europe finally concluded on Monday night. But no one believes for a moment that the crisis is over. Greece will be back for more money, and will fail to meet most of the conditions attached to the latest deal. So, in time, will Portugal, and probably Italy and Spain. This story still has a long way to run.

Most of the discussion of the sovereign-debt crisis has been looking at the saga as if it was purely an economic question. Will the currency EURUSD +0.62% be stabilized? Will a fiscal union iron out the imbalances? Can Greece and other countries regain competitiveness through an internal devaluation, or will they have to reintroduce their own currency? Is it all the Greeks and the Italian’s fault for running up too much debt — or is the fault of the Germans for not spending enough, and running up big surpluses?

But actually this is no longer a branch of economics at all — it is a branch of game theory.

Game theory is all about a complex set of negotiations between parties with very different interests — and so with very unstable and difficult-to-predict outcomes. It was first developed in the 1950s, mainly by the brilliant economist John Nash.

So what game is being played in Europe right now?

There are several possibilities from the game-theory textbooks.

Such as?

Perhaps most obviously, this is a game of “chicken.” Two drivers head for a single-lane bridge from opposite directions. If neither swerves, they both crash into each other. Because the costs of swerving are trivial, and the costs of a collision are so high, each driver assumes the other will give way because that is the rational thing to do. Instead they end up smashing into each other.

Greece and Germany both assume the other side has too much too lose not to give in. The Greeks could find themselves slung out of the single currency, and unable even to pay for their oil imports. The Germans could find themselves with a bankrupt banking system, and a soaring new currency that sends the country into a deep recession.

So it is easy for both sides to imagine the other side will blink first, and give in to the other side’s demands. Another bailout is cheap compared to the costs of failing to agree. But it won’t necessarily happen.

Then there is the “diner’s dilemma.” Ten of us go out for dinner. We split the cost equally. Each of us decides to order the most expensive thing on the menu even though it is only marginally better than the cheapest — because once the extra cost is split 10 ways it is a trivial sum. But if all 10 of us make the same calculation, we end up ordering 10 of the most expensive dishes — and a far more expensive night out than any of us actually wanted.

Again, it is easy to see that happening in the euro zone. Heck, why not get the European Central Bank to print some more money? After all, it can use it to buy our government’s bonds, and we can have higher public spending on the cheap. The costs get spread among the other 16 members of the euro. But, of course, while that makes sense for any of us individually, if we all do it, it gets very expensive — and we all end up being broke.

Then there is the “prisoner’s dilemma.” The police arrest two men and interrogate them separately. The police don’t have enough evidence to convict either of them of the crime without the prisoners’ help. The cops offer each man a deal. If you testify against your partner you’ll get off and he’ll go to jail. Because they can’t cooperate with each other, both men end up betraying each other and getting a long sentence from the judge.

Again, it is easy to see how that applies to the sovereign-debt crisis. If the peripheral countries reined in their public spending, and reformed their economies, whilst the core countries boosted their public spending, and allowed debt and consumption to rise, the imbalances might gradually start to even out, and the system would slowly return to some form of stability.

But because they find it impossible to cooperate, or to enforce any agreements that they might make, it isn’t going to happen — and everyone winds up in jail.

There are other ideas from games theory that are just as relevant. In the “ultimatum game,” two players have to decide how to allocate a pot of money between them — rather as the Greeks and Germans do. In the “pirate game,” five rational pirates have to split up their loot according to their seniority. In the “war of attrition,” two sides keep arguing over the same prize, ignoring the fact that the costs of the argument eventually start to outweigh the value of the prize itself — just as, right now, everyone keeps trying to ‘save the euro’ with more and more extreme austerity, without pausing to ask whether it is really worth preserving if this is what it needs to keep it alive.

The one thing that game theory really teaches us, however, is that in certain circumstances people do not always reach mutually beneficial outcomes. In fact, they quite often end up with a result that is terrible for all of them.

You’ll read plenty about how the euro won’t break up because that would be bad for everyone — so in the end, leaders will get their act together and do the sensible thing.

Don’t believe it for a moment. A catastrophic outcome is quite possible. The only rational thing to do is to prepare for the worse.

Matthew Lynn is chief executive of Strategy Economics, a London-based consultancy. His latest book, ‘The Long Depression: The Slump of 2008 to 2031,’ is published by Endeavour Press.

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