Tuesday, 18 September 2012

Incredible Threats?

Yesterday, Yanis Varoufakis presented an article over his concerns about the OMT (Outright Monetary Transactions) program announced by Mario Draghi almost two weeks ago. In the article, Yanis, after depicting the arguments in game theory style, states that if Mario Monti decides to take up Draghi's offer for OMT, then the former would be better off by not enforcing reforms and austerity measures in Italy, because the threat that Draghi will stop OMT operations in incredible. In essence, Draghi will be caught between a rock and a hard place.

Yanis states that it would be disastrous for Draghi to back out once he has agreed to fund Italy (or any other country for that matter) since the result would be that Italy would most likely exit the euro. However, I think that in his analysis, Yanis fails to state three points:
1. Money will not be given as a lump sum as soon as the agreement is signed. What should take place is an instalment-based assistance just like in the case of Greece.
2. Economic theory (and game theory) states that rational people will choose what is best for themselves under certain circumstances. However, behavioral economists have proven that people are not at all like the rational beasts economists perceive them to be. (Paradoxically, economists themselves are not as rational as they think they are)
3. The consequences for Italy if the country exits the Eurozone.

If game theory was right, it would mean that the Greek government would have an incentive to exit the Eurozone and declare bankruptcy as soon as
the first installment from the Troika arrived. It would be the perfect game theory setup: Greece would have just received a great amount of money which would allow it to finance some of its expenses, few austerity measures had been implemented at the time, and resentment towards the Greeks had reached its maximum. Then why did Greece not exit the euro?

To answer that I would have to take you back to my Effects of a Euro Collapse article. An exit is not only undesirable by the rest of the nations which choose to stay in the Union, but to the exiting nation as well. Although some of the consequences of a euro collapse are still unknown, the huge inflation which would occur would make the exiting nation far worse off than the ones within the Union. Bond spreads have reached 6% during the Eurocrisis. One may imagine how high they could reach if a nation left the euro. If depression is now visible in Greece, you may imagine how worse it could be had the nation exited the Union.

Giving money to ailing nations by way of periodic instalments instead of a lump sum at the beginning holds them responsible to their actions. Would Greece be better off if no austerity measures had taken place? I do not think so. They would, in the best case scenario, just postpone the inevitable. Would the Troika stop paying instalments to the Greeks if their austerity measures and reforms had not taken place? I think they would. The same idea should hold with OMT. If Draghi decides to back up Italy without the nation having done what it said it would, there exist many people in the ECB which would prevent him from doing so. (Most notable Mr. Asmussen of the Bundesbank)

Yanis has correctly stated that Mr Draghi believes that it is a political issue whether nations would meet the troika-supervised EU-IMF-ECB conditions. What else would it be? As much as governments are afraid to promote austerity measures and reforms, they are even more afraid to exit the EU. With perfect reason as well! Even larger nations like Spain or Italy are far better off within the EU and the Eurozone than out of it. It would be catastrophic for a country to move from the common currency to a national one, especially in such a period of high pessimism.

Large firms and banks have always tried to manipulate, with one way or another, political will in their nations. The major difference here is that several large corporations in the EU support both a unified EU-wide regulatory authority, as well as the break-up of several large banking institutions, as this article in Der Spiegel states. It is to the best interest of both firms and government if financial institutions are more stable and efficient. All that remains to see is Erkki Liikanen's (Finland's Central Banker) plans towards this end.


  1. Beautiful argument for a case where real-life concerns (politicians afraid of Grexit) overrule a mathematically perfect hypothesis (application of game theory to Greece and the EU's relationship).
    I noticed that many of your articles are reflections on other economist's posts. Could you tell how did you build up the "thought network" of blog's you reflect on? I'd find the description of the process fascinating.

    1. If I understand correctly, you are referring to the way I select which blog posts to comment on. To be honest, I prefer to choose posts where although the economic theory employed makes sense, economic reality is much more different than what the analysis of the theory. For my view on economists, their ideas and real-life economy read this: