Cost of collision is too high for both parties
By Dimitris Kontogiannis
As Greek elections get closer, the game of chicken between the country and its creditors is bound to intensify. However, this does not mean that a mutually acceptable solution cannot be found after the elections by having both sides renegotiate some terms of the bailout agreement despite all the current signaling to the contrary from the EU and the IMF. After all, the MoU (Memorandum of Understanding) itself allows for amending or supplementing the conditions from time to time.
Game theory was developed in previous decades to study strategic decision-making by using mathematical models. The study of complex negotiations between intelligent rational parties with different preferences leading to various outcomes was at the center of interest when John Nash, a bright economist, came up with a solution in a game called Nash Equilibrium.
In a game with two players, Nash Equilibrium implies, each player makes the best decision he/she can by taking into account the other player’s decision, but it does not mean the best payoff for all the players.
Back to the present, many economists and commentators think the situation between Greece and its trading partners, mostly Germany, can be described by the so-called game of chicken.
In its typical form, two cars head for a single-lane bridge or at each other from opposite directions. If neither driver backs off, they crash into each other. They both understand the cost of a crash will be too high and each rationally assumes the other will give in.
It is obvious that the worst thing that can happen is for both drivers to collide. The best thing that can happen is for one side not to yield and let the other side become the chicken by conceding. Being chicken is the second-worst outcome, but much better than dying. Still, a cooperative outcome in the game of chicken can be reached when both sides back off, no one is hurt and no one can call the other a chicken.
Undoubtedly, the direct costs of a collision between Greece and the core of the eurozone appear bigger for the former. The direct exposure of eurozone countries and the ECB to Greece is estimated around 290-300 billion euros according to two different studies by Barclays and Nomura. Assuming a 70 percent haircut, the total cost is around 200-210 billion euros, which is big but manageable if one takes into account that the economy of the eurozone is around 9.5 trillion euros. Still, some countries like Spain and Italy with exposure of 37 billion and 55 billion euros respectively may find it more difficult to absorb.
However, it is extremely difficult to estimate the indirect cost of a Greek exit from contagion -- this may be quite high if financial markets lose confidence in the eurozone. Moreover, it is reasonable to assume that markets will view a Greek exit as the beginning of of the eurozone’s unraveling. This could change if Germany and other core countries are ready to guarantee the safety of bank deposits and the repayment of debts of other euro-periphery countries, and the ECB is prepared to engage in large-scale interventions in the bond and currency markets. We are not sure whether some of these moves will be approved by Germany’s constitutional court, while others will definitely be in breach of existing EU treaties, further complicating matters.
As far as Greece is concerned, there is no doubt that the economic cost of a euro exit would be catastrophic and have negative geopolitical consequences. Inside the country, the need for law and order, and the descent into economic misery would strengthen the two opposite extremes of the political spectrum at the expense of mainstream parties.
A rational game
So, no rational Greek government would chose to quit the euro unilaterally, especially if one considers the 80 percent approval rating for the single currency. Since it cannot be legally expelled, Greece can only be forced by, let’s say, having the ECB cut off support to the Greek banking system, but this would not look good.
From the point of view of any new Greek government, the preferred strategy would be to negotiate changes in some terms of the bailout agreement by presenting a reasonable plan to put public finances in order and turn around the economy while pledging to stick to structural reforms.
It is hard to imagine how the other eurozone countries will say no to such a plan when the direct costs of a Greek exit are high and the indirect costs are difficult to estimate. Moral hazard may be an argument against accepting such a Greek plan but one should remember that decision-making at the eurozone level, which assigned too much weight to moral hazard, has not produced good results.
If it is indeed a game of chicken between Greece and the core of the eurozone, it is in the best interest of all sides it leads to a cooperative outcome where a collision is avoided. Especially when the possible miss of budget deficit target and the slower pace of reforms call for renegotiation of the MoU regardless of political intentions.