Like many people, I’ve been watching the situation in Greece with increasing concern. They are now officially in default with the IMF (the last country to default on an IMF loan was Zimbabwe), and while that by itself isn’t that big of a deal, the flow-on consequences for Greece are very damaging. The Greek government can no longer receive new money from the ECB, and to prevent all the money from flowing out of the country, the Greek government has instituted capital controls (severely impeding international trade) and have prevented people with Greek bank accounts from withdrawing cash – effectively freezing the assets of every Greek person.
While this emergency rages on, no one in charge seem to be doing anything about it – or at least doing anything useful. The Greek government called a referendum on accepting the bailout offer (and the Greek people rejected an offer that was no longer on the table), and despite the demands by the Greek government for more latitude Chancellor Merkel has utterly refused to offer any.
A lot pixels have been darkened arguing over who should take the blame for this Grade A Clusterfish, and while there is a lot of blame to go around that’s not what I want to write about. As Keynes put it, economics is a series of technical challenges, not a morality play; and in any case assigning blame to Greek fecklessness or European imperialism won’t make this problem any easier to solve. Instead I want discuss why the negotiations have fallen apart, and how Game Theory concepts (including the beloved / despised Signaling) can help explain why this situation has gone so horribly wrong.
First off, we need to understand how we got here. Greece has always been a country that spends significantly more than its taxes permit (or, if you prefer, taxes significantly less than its spending requires). This led its creditors to charge high rates of interest for its sovereign debt for fear they would devalue their currency as a way to escape high debt levels. Then Greece was accepted into the Euro. This eliminated devaluation risk, and since there were financial requirements for entering the Euro, the bond markets decided that default risk mustn’t be as big as they had initially thought.
With their newly-lowered interest rate, the Greek government ran larger deficits. This didn’t cause any immediate problems, but it is inevitable that any country running a structural deficit will eventually reach a point of fiscal crisis where it can longer use borrowing to meet its deficit. This will most likely happen in economic conditions that are hardest on a government’s budget – such as a recession when taxes revenues fall and benefit payments rise.
That recession came in 2008, as we all know. And the added stress from this unusually long and deep recession proved too much for Greece’s government, given its fiscal condition at the time. And so a group of European governments (led by Chancellor Merkel) and the IMF offered The Greek government a loan to pay their existing creditors, both to protect those creditors (which were mainly European banks) and to safeguard the idea of the Euro as an enduring economic and political union. But those loans came with tough conditions – including an austerity programme that was unpopular enough to unseat 2 governments and put Syriza, which was a fringe party on the left in control of Greece’s government after it campaigned specifically against austerity.
This leaves us with two questions that we need to answer in order to explain why this situation persists – why are the Europeans demanding austerity, and why won’t the Greek government accept it?
In the field of Game Theory, when a person or group states an intention to do a thing, this is referred to as a a Commitment. Importantly, and unlike common English, players in a game are not necessarily expected to follow-through on their commitments. In The Prisoners Dilemma, each player may commit to cooperate, but still defect without having violated the game’s rules. This represent one of the most basic problems with coordination between people who do not have an ongoing relationship – how do I trust the other party will keep up their end of the bargain? They may state a willingness to cooperate, but as the saying goes, talk is cheap.
There are two main technique for allowing strangers to cooperate. The most powerful is Binding Commitments – unlike the regular kind binding commitments are enforceable by some external party that ensures breaking a commitment is costly. If the players in a Prisoners Dilemma can sign a legally-enforceable contract to cooperate, they need not worry about defection, leading to both of them being better off. This is why contract law is one of the foundations of a functional civilization – without it society tends to fragment into little villages where people only do business with those they have stable relationships with.
But contract law is not all-encompassing. Some areas don’t have contracts due to a cultural aversion (such as friendships or romantic relationships), or the law refusing to enforce them (like criminal contracts) or, and this is important for our purposes, contacts where there is no external party with the power to enforce compliance. By their very nature it is very difficult to force a sovereign government to do anything it doesn’t want to do (war is the traditional method). While a treaty or other contract with a sovereign government is a commitment, it cannot be binding – one of the ironies of Game Theory is that the power of a sovereign prevents them from using one of the most useful cooperation tools ever devised, a tool any random person can make use of.
So if binding commitments are unavailable, what else is there? The lesser, but still useful alternative is the Credible Commitment. A commitment is credible if it is only in your best interests to make the commitment if you intend to keep it. Credible commitments are a form of Signal – an action that it only makes sense for you to perform if you possess some characteristic that is otherwise difficult to detect. For example, if you’re a seller of no particular reputation it may be hard to convince people to trust your product (in the absence of consumer protection laws). But if you offer a money back guarantee, well that’s something that is much more expensive for a seller of bad products than a seller of good ones.
So how does this relate to the Greek situation? The German government and the IMF want to keep Greece in the Euro, but aren’t prepared to finance a Greek deficit indefinitely. So they need the Greek government to accept structural reforms (including either tax increases or spending cuts). On the other hand, it is quite clear that the Greek people aren’t interested in austerity – Syriza was elected as an anti-austerity party, and there is a good chance that they would refuse to engage in austerity after getting what they want. What the IMF and the rest of Europe needs is a credible commitment from Greece, a signal that they are willing to accept political pain to reform their Budget. And that is why they are demanding austerity now, even if austerity later would be better for Greece’s economy.
And it would appear that their demands have in some sense worked, the Greek government’s inability / unwillingness to agree to the bailout terms has provided the IMF and Chancellor Merkel with the information they needed, even if it isn’t the result they wanted.
Image: Flag of Greece, released into the Public Domain