Greek Game Theory: Default, Devaluation, Austerity, Deliverance?

The media is stuck in a twilight zone when it comes to Europe. It has been repeating the same headlines and articles for months now. If Greece is a slow motion train wreck, the emphasis is on ‘slow motion’. Meanwhile, the stock market has been all over the place.

But there is a funny side to the Greek crisis. It’s thrown a spanner in the works of contradictory conventional wisdom. The two armed economist is making a comeback.

Who? The two armed economist is the one who always says ‘on the one hand X, but on the other hand Y’. That’s an economist’s way to say ‘I dunno’. Most economists are one armed and so only give you the X or the Y, depending on their source of income and career goals. The two armed economist is always driven to acknowledge his two hands each have a mind of their own.

That might sound like a pain in the neck, but the two armed economist is also the only smart and honest economist around. That’s why you can trust him when he says ‘I dunno’. And why you should base your investment outlook on his predictions.

One way of doing that is the Permanent Portfolio – the only true diversification strategy. It’s an equal mix of four assets, the idea being that each asset outperforms during one of the four different investment environments. It’s the ultimate defensive strategy. So if the two armed economist gets his prediction wrong (he has never been shown to be wrong), you still benefit.

One of the four asset classes in the Permanent Portfolio is stocks. But it’s tough to figure out which ones to actually buy. We’ll finish today’s Markets and Money on that note. But first, back to what the two armed economist has to say about Greece.

It is alleged that Greece has two problems. An overvalued currency and too much debt. The link between the two is that a cheaper currency would spur on economic growth and thereby alleviate the debt problem. So far so good. It all makes sense. But now everything becomes completely muddled.

Greece has four options based on its two problems

  1. Default and stay in the euro
  2. Default and leave the euro
  3. Don’t default, and stay in the euro
  4. Don’t default and leave the euro

Economists might present the four options like this:

The table is based on a graphical representation called Game Theory. It was invented by schizophrenic genius John Nash, who was portrayed in the movie A Beautiful Mind. The idea is to figure out what the Nash equilibrium is – the rational combination of multiple decisions. (We’ve manipulated the way it works a little, but you’ll still get the point.)

Currently, the Greeks have neither defaulted (meaningfully) nor left the euro. They are in the ‘Current Situation’ box above. Should they do both – default and leave the euro – or only one of the two? Which one? A game theory table usually helps you answer the question.

But there’s a problem. Nobody can agree on what a Greek default and Greek devaluation would actually mean. In game theory terms, nobody can tell you what the payoffs are. If we knew that the payoffs from defaulting but remaining in the euro were highest, then that would be the choice to make. But we don’t know the payoffs for any of the four outcomes. People can’t even agree on what each scenario would mean for Greeks, Germans, Australians or anyone else.

That’s why the Greek crisis has exposed conventional wisdom’s contradictions. All of a sudden, the contradictions are playing out in reality, real time and very close to home, even for Australians. The ASX200 has been beaten around severely on the Greek news cycle.

Let’s look at how the conventional wisdom of devaluation (leaving the euro) has been exposed, and then how default could have all sorts of bizarre consequences which make payoffs unpredictable. Acknowledging just how unpredictable both of these upcoming decisions are will have an influence on how you invest. What you might think is the resolution of the euro crisis could actually result in collapse. So even if the Greeks make up their mind on default and devaluation, it doesn’t mean we know what will happen to the price of the investments you own.

If the Greeks leave the euro, their currency would collapse in value. Let’s say it halves in purchasing power. According to some, this is the medicine Greece needs. It would spur an economic revival because Greek goods and tourism would be cheap for foreigners.

But what about the ability of Greeks to buy things from overseas? If the costs of petrol and German trucks doubled (because the currency halved), what would that do to the Greek economy? Could it take advantage of an export boom if the capital it needs to import is more expensive? And what about the Greek price level? If the currency halves, but prices double, then nobody has gained anything. It’s very difficult to know whether the advantages of devaluation would outweigh the disadvantages.

When it comes to default, would that lock Greece out of funding markets for many years – forcing Greece to balance its government budget? If yes, then why not accept austerity without the pain of a default? Default might solve debt problems, but what would it do to the economy? It’s very difficult to know whether the advantages of default would outweigh the disadvantages.

To summarise, there is a debacle not only in what we don’t know but also in what we think we know. (Now thought we knew.) The two armed economist has punched with one hand for every jab with the other.

Even the Greeks are confused about what defaults and devaluations would amount to. It’s very difficult to know whether their belief in endless German bailouts without having to implement the required austerity is incredibly clever or delusional. This remarkable article from Reuters explains the bizarre Greek attitude towards the question of the euro and austerity.

‘However bad their prospects, many Greeks seem to think that since money to bail them out was found in the past, it will be found again, whatever politicians say.’

This is the old turkey problem. Just because the turkey has been fed every day for several years doesn’t mean it will survive the next Thanksgiving. So do the Germans really need to save the Greeks in order to save the European Union and its banks? Or are the Greeks relying on German altruism – not something we Germans are known for. Who has whom over a barrel? And if neither one knows who’s on the barrel and who isn’t, what happens? It’s certainly an amusing picture. Not that we want to see the illustrated version.

Bill Bonner came up with a much better metaphor on Monday:

But here’s the most exciting scene in the whole show. Greece and Germany are playing chicken!

Greece presses down the accelerator and heads for Germany. “If you force us out of the euro, all of Europe will go up in flames,” say the Greeks.

“Oh yeah?” say the Germans, turning on the speed in their Mercedes, “ve’ll see about that. Ve haf airbags!”

Here is our favourite part of the Reuters article:

‘Solemn warnings from abroad that Athens cannot stay in the euro while rejecting the terms attached to the billions offered to pull Greece out of its financial hole are widely disbelieved in a land that considers itself the envy of foreigners.’

The Greeks have either lost any connection with economic reality, or have figured out that political games trump economic reality in Europe. Even if they are right about the suspension of economic law, we always point out that this doesn’t work indefinitely. But it sure can work for a very long time. Still, austerity, in some form, will arrive in Greece eventually.

Oh no, there’s another way the dreaded Greek Game Theory table could be displayed. With austerity instead of default as one of the decisions. (We couldn’t draw a 3 dimensional game theory matrix, with all three decisions in it, for you.)

This table is even more bizarre than the previous one because, not only are the payoffs unclear, but some of the scenarios might be impossible. For example, would the Germans bail out the Greeks if they don’t implement austerity? We don’t know the payoffs, so how can we know if they would? Do the Germans even know?

If a Greek debacle means contagion spreading to Spain and Italy, then you’d hope the Germans fork over their cash. Otherwise we will see a replay of 2008 or worse. Probably worse, because governments won’t be there to backstop the private sector with bailouts.

Now looking at the left hand side of the Greek Game Theory table, if the Greeks left the euro, would the Germans support them? If not, it’s likely the Greeks would be left with nobody stupid enough to buy their government bonds. That means forced austerity.

If you’re confused about all this, that’s the point we’re making. Nobody knows, when arguing for one course of action or another, what that course of action actually results in. The more passionately they argue, the more difficult it is to believe they have a clue. Not that we won’t have a go too.

The game theory story becomes completely ridiculous when you consider that there are a vast amount of different parties making decisions. It’s not just the Greeks having to make tough choices. The Germans have to decide on bailouts, the Spanish on their own defaults and so on. The more parties, the more possible outcomes in the game theory table. And still, nobody can agree on the payoffs.

So what do you do with your stock market investments? You forget about them. Well, you buy the kind of companies that will be around in 100 years’ time and pay a good dividend, and then you try and avoid fretting over their share price. The idea being that a recovery will come, however long away it is. And you will have been collecting a dividend in the meantime.

What kind of stocks fit the bill? Food might be a good place to start. And we’re pretty sure the world won’t give up drinking if bad times come about. The company we have in mind even has the word ‘cash’ in its name.

There are a few other strategies that allow you to enhance your returns. For example, at what price would you be willing to buy Woolworths (WOW) shares? Perhaps a few percent below the current market price? Well, you’re in luck, because someone may be willing to pay you money to buy them at that price. That is, they are willing to pay you to enter into an agreement to buy their WOW shares below the current market price.

The catch is, the actual purchase only happens if the price of the WOW shares fall below the price you have agreed to buy at. But you still have to buy at the agreed price – that is above the market price. You get to keep the upfront cash payment even if the purchase doesn’t go through though. So if WOW doesn’t tumble, you’ve made a small return without buying above a price you’re comfortable with.

We’re working on a report to explain the strategy. And we’ll keep you posted.


Nick Hubble
for Markets and Money

From the Archives…

Investing in Gold as World Economies Falter
2012-05-25 – Eric Fry

A Hard Dose of Medicine for the Greek Economy
2012-05-24 – Greg Canavan

Why Sooner or Later in Europe Someone Will Have to Pay
2012-05-23 – Dan Denning

To the Class of 2012
2012-05-22 – Bill Bonner

The Early Stages of a European Bank Run
2012-04-21 – Dan Denning

Nick Hubble
Nick Hubble is a feature editor of Markets and Money and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about Markets and Money, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails.

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5 Comments on "Greek Game Theory: Default, Devaluation, Austerity, Deliverance?"

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On either of your Game Theory grids there is only one solution actually proposed. All others are just extensions of or variants of the same scenario we are currently in.

That one ‘solution’ is detailed as ‘Devalue and get the house in order’.

Seems Mr Nash’s theory as described by Nick, works perfectly well.


ELA….otherwise known by the likes of us as FUDGE

“first rule about ELA is you don’t talk about ELA”

Gary Lee

hey, sounds “the missing chair” game the Euro both Private and Public sector are playing, when the music stop who know what happen.

The main point you are missing that going along with the Greeks is simply unsustainable. It would de facto mean replacing the total Greek debt by EZ-taxpayer one plus propping them up for the time to come as well. For Greece it would not be a real problem we are talking around 500 Bn max or so. But no one believes that you can sell austerity in Italy and Spain if the Germans can be made paying the bill. Which is way beyond Germany’s means. So not shorter but medium term it is anyway simply Germany’s call do they go… Read more »

If the PIIGS would of dropped out of the EURO 2 years ago they would all be back on the road to solvency.
Since they didn’t now is the time!

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