The European Crisis Game they play: “Forecasting” the results of the July 21, 2011 Eurogroup meeting

I suppose this post applies to most decisions under crisis, but I suppose that this meeting is what everyone wants to know about. Right?

So I’ll have a shot at it…

I am actually going to go against everyone and argue that at the end of the day tomorrow, the EU will have taken some very productive, if not decisive, steps towards fixing the Sovereign Debt Crisis. This is a high risk, high return “forecast”. However, that’s not the reason I’m doing it. Nor, I believe, is it the result of wishful thinking, althought I do hope this will happen. In the next few lines I’ll lay out the game that is being played, the players, their preferences, the pressures that they are faced with and the actions available to them. Finally, I will describe the consequences of my “prediction” being proven wrong, not so much for me, but rather for us and for our leaders. Clearly, I’ll look stupid. However, that’s nothing in comparison to the size of the troubles that’ll be galloping our way.

The players

Instead of analysing the game with all its players, I will divide them in two groups. The Reticent Core (RC) and the Needy Periphery (NP). I will use these terms interchangeably with Merkel and Papandreou. The RC is, at present a net contributor to any form of assistance. The NP is a net receiver.

The Game

Although intergovernmentalism and European integration in general canbe seen as a cooperation game it occurs to me that as far as reform under a crisis environment is concerned, a game of chicken might be the best analogy, particularlythe a War of Attrition (see here and here for recent updates) variant. In its national-international duality, this is also a two-level game for every single country.  Everyone want to reform, but no one wants to bear the costs of reform. Because both players can bear the cost of delaying for only so long, both wait each other out, and whoever blinks first looses. However, I fear that Germany fails to understand that the periphery is actually playing with its eyes closed, given how much as it has blinking its been doing. There is hardly anything more that Greece can do in terms of weight lifting.

The plays (the policy choices)

The possible plays have been highlighted recently. The two most desirable policy solutions are on par restructuring and or EFSF repurchases of national debt. The first would cause,at best, a temporary selective default rating, and although it would require no national political procedures, it would be lax enough that it could lead to an uncertainty increasing scenario, if countries took too long to establish the terms of the restructure. Both would be enhanced by an extension of EFSF loan maturities and lower interest rates. To this, Germany seems bent on adding some sort of less subtle restructuring, in order to say that it forced the private sector to share the pain.

Unfortunately, neither of my main two choices is available. According to reports by Reuters and the FT, based on a leak, there are four policy choices on table:

The first option is a variation on a debt-swap option first suggested by Germany. In order to get investors to trade in their current holdings for new, longer-maturing bonds (which would give Greece some breathing room before having to pay off their debts), the IIF suggested “credit enhancements” for the new bonds they would get. This could involve getting the bonds from the eurozone’s €440bn bail-out fund, for instance.
The second option is described as “PSI option without public sector credit enhancement (e.g. the French proposal)”. This is a softer version of the German proposal, which wouldn’t have any “credit enhancements”. The original French proposal would have been more a roll-over than a swap. In other words, rather than getting bondholders to trade in their current holdings for new bonds, they would instead wait until the bonds come due – and then reinvest the proceeds in new, longer-maturing bonds.
Option three is “Low interest rate and very long maturities for the EFSF loans”, which is the most straight forward option. The EFSF is the European Financial Stability Facility, which is the formal name of the eurozone’s €440bn bail-out fund. Right now, all bail-out countries (except Ireland, for political reasons that could be the subject of another treatise) pay 2 percentage points on top of the EFSF’s borrowing costs when they get seven-year bail-out loans from the EFSF. This plan would lower those rates, and extend the maturities from seven years to as much as 30 years.
The final option is “PSI based on tax on the financial sector”, the main topic we wrote about in today’s paper. This option comes a bit out of the blue, but is attractive to many for a couple reasons. It would enable the Germans and the Dutch to say they’re getting money from the private sector to help Greece – and it would also avoid a default on Greek bonds, which is the issue that has spooked the markets and raised the ire of the European Central Bank.

There are off course other policies with their own consequences.

The payoffs

The benefits of stabilization are quite clear.

The problem is unavoidable and as Brugel showed, the solutions designed so far are insufficient:

The cost of bailing out the PIGs would be some fraction of those €1.3 trillion. However the problem is not contained to the NP. As I argued before, the interdependences within the Eurozone, and the wider EU, are very strong.

The cost would be a progressive contagion (as has started to happen with Italy) that could lead to a sum total of €9.2 trillion if only contained to Europe (and only considering the exposure of the banking sector). (see theExcel file here for the BIS data). If you do the math, the potential opportunity cost of not rescuing the periphery is around €7 trillion…

Moreover, the fallback from a European crisis is not contained to the region. According to the IMF, a decrease in bond market volatility would benefit the European and the Global economy. In its study of debt spillovers, it concluded that growth spillovers of a European crisis affect the whole world, but the grunt of the pain will be contained to the Europe (and North Africa).

However, regarding financial spillovers, it concluded that the whole world would share in the pain, due the fact that at 1/5 of the world financial sector, what happens in Europe reverberates all over the world.

What these facts should impress on you is that the problem in the NP can very easily become a problem of the core of the GC and that the problems of the core of the Eurozone are the problems of the whole world.

Nonetheless, for the purposes of this game, what matters is that the players involved would suffer. Not so much the rest of the world.

The Pressure agaisnt the Status Quo

Merkel (with her camp) stands alone in the minority view. The ECB, the EC, the IMF, the USA and the other member states demand more pro-active policies. Kohl and Rühe, grandees of her own party, oppose her. Her national parliamentary opposition, opposes her pro-status quo position and and are gaining electoral support, while she and her coalition ally are falling in the polls.

Moreover, her own personal popularity seems to be fading:

Adding up the pieces

I believe that although Germany can wait the NP, the cost is just becoming too high too quickly. I believe the pressure from all sides is just too much and the cost is just too high for Merkel to continue to stoically stand her ground. It might not be what I want, but surely she can’t be so stubborn that nothing will come off tomorrow’s meeting.

Consequences of Defection

As I am finished this post, she still wasn’t budging. But there are still 36 hours before markets open on Friday and react to whatever has been decided (or not). If the status quo prevails on Thrusday, then it will probably be a simple postponement of the inevitable rather than the last word on the issue. Most likely, if the result of the meeting tomorrow is the prevalence of the status quo, then the result will be that the ECB will have to intervene, because markets will start dropping European stocks and bonds like rain in a storm. It will have to intervene through it’s Securities and Market Programme, purchasing Italian, Spanish and Possibly even Belgian bonds, the quantity of its overnight and other short term loans to these countries’ banks will also increase and it may have to allow ELA to Portugal and Greece. When all hell has broken loose, then they’ll implement some mix of the policies discussed above.

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