Lots of people have raised the suggestion of applying game theory to the the Greek debt crisis. I haven’t attempted this, reflecting my general scepticism about game theory in the absence of a well-defined strategy space. But now the Greek government and public have made, what is, in effect, a final move. In view of the No vote, Syriza can’t accept a deal that doesn’t include an explicit debt write-off or one that obviously crosses its stated red lines. Within those parameters, its clearly eager for a face-saving compromise.

For the other side (effectively the Troika and the German government), since Syriza’s move has already been made, the problem has now been reduced to one of decision under uncertainty, which is something I am comfortable with. More precisely, it’s a choice between a “safe” option, with an outcome that is fairly predictable, and a “risky” option where the outcome is uncertain.

The safe option for the European insitutions is to cave in, write off lots of debt and lose a lot of face. (Added in response to comments: the loss of face will particularly affect the elites in peripheral countries that accepted austerity, and will mean a further shift away from austerity in general. But the effect of a non-disastrous Greek repudation would be far greater).

The risky option is to foreclose, and force Greece out of the eurozone, and leading to a repudiation of debt. The possible outcomes involve several interdependent sources of uncertainty

  • Whether the Greek economy does so badly that the Greek public regrets their choice and throws the government out at the next opportunity
  • Whether exit from the eurozone is followed by exit from the EU
  • Whether the process generates a broader financial crisis

From the European viewpoint, all of these outcomes except one would clearly be worse than an immediate backdown. If Greece leaves the euro and recovers, the whole austerity project will be shown up as the failure it is. If Greece leaves the EU (and especially if the UK also does) the European project is done for. And, while the institutions seem to have convinced themselves there won’t be a financial crisis, their past track record gives little ground for confidence.

So, the only case that could conceivably counted as a win is the one when the Greek economy fails, but Greece stays in the EU and there is no immediate financial crisis. I’d argue that, even here, the damage to confidence in the euro and to the European project would be greater than the costs of a backdown. If that’s right, then the “sure thing” principle applies to this decision. Backing down is the best option with probability 1.

Even if least-bad case is regarded as slightly better than a backdown, any reasonable calculation of expected payoffs for the institutions concerned would indicate that backing down is the rational choice. That doesn’t mean that such a choice will be made. People aren’t generally rational after all. Moreover, individual rationality may not be the same as institutional rationality. Quite possibly, failure will be seen as career-ending for key individuals, notably Lagarde, Merkel and perhaps Juncker. So, they may prefer institutional disaster to personal failure.

From the viewpoint of Australia and the world at large, there’s no doubt about the outcome we should prefer. European austerity has been a complete failure and raises the threat of a new global financial crisis. The sooner this delusion is abandoned, the sooner it will be possible to address the real source of the problem: the unsound and unsustainable growth of the financial sector.

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