Tito's Blog

Euro Government Bonds Monthly Redemption Calendar 2012

Now you can scare your friends at dinner hinting at the hundreds of billion euros of government debt coming due every month in Europe in 2012. Happy new year!

Source: Goldman Sachs via ZeroHedge.

Game Theory On The Eurozone Crisis

I’ve been thinking about the European debt crisis in game theory terms. Let’s assume for simplicity that there are only two players: a European core country (solvent government and banking system, current account surplus) “Germanland” and a European periphery country (insolvent government and banking system, current account deficit) “Greetaly”.

I think that the strategy matrix of this 2-player game would be the following:

Greetaly will be able to stay in the Eurozone and avoid major economic shocks (i.e. banking system collapse or adoption of a new devalued national currency) only if Germanland is willing to assume its debt and if Greetaly accepts to give up its sovereignty by implementing a fiscal policy imposed by its northern neighbor.

Even then, I believe that in order to have a stable economic scenario, Germanland would need to “double down” and agree to fiscal transfers (or a “Marshall Plan”) benefiting Greetaly, otherwise the depression in the periphery would create social tensions and increase the likelihood of Greetaly eventually choosing to exit the Eurozone.

The only real choice left to Greetaly is to either accept foreign-imposed austerity or to “press the red button”, i.e. choose to default and/or leave the Eurozone now.

Below is a possible payoff matrix for Germanland and Greetaly. What makes it interesting is that short-term and long-term payoffs are different.

Germanland might have a hard time to politically justify another round of bailouts and even more so to launch a “Marshall plan” (with negative short-term effects), but that would be the best choice in the long-term. The bailouts today represent the necessary cost of a solid export-driven economy at nearly full employment.

Similarly, Greetaly would suffer significant shocks in the short term if it decided to default and exit the Eurozone, but on average as a country it would probably enjoy a faster recovery thanks to suddenly higher competitiveness, growing exports, lower debt overhang (as Argentina did).

Given that political decisions tend to optimize short-term outcomes and because of the high short-term cost of the Eurozone exit decision by Greetaly, the most likely outcome is the suboptimal box highlighted in yellow. Both Greetaly and Germanland are worse off in the long-term than in the optimal box highlighted in green.

There is a dominant strategy in the long-term, which would be a decision by Greetaly to exit the Eurozone, although at an extremely high short-term cost.

European Governments Cash Flows 2010-2011

All you need to know about European government debt in two pictures below from Nomura research: