A Game of Texas Hold ‘Em in Greek

Good poker players study probabilities. Great poker players study their opponents. Economists study game theory. We look at the potential outcomes from the decisions of players and then, based on assumptions of their objectives we predict outcomes. We thought we’d apply a little game theory to the unfolding Greek debt fiasco and make a prediction of the outcome. The details of the mess can be found in a recent article from Reuters.

The players are Greece, the IMF (International Monetary Fund) and the other members of the EMU (European Monetary Union). Greece has a mountain of debt that will require large cuts in government programs or excessive tax hikes, neither of which are politically appealing. Greece would like to restructure their debt by unilaterally lengthening the maturities. Rating agencies have indicated that they will treat this as a default.

The IMF has stated that they will not extend further aid to Greece unless the other EMU members guarantee the Greek debt. This is a political problem for Germany, Netherlands and Finland. Voters in these countries don’t want to risk assuming Greek debt when they, themselves remain committed to conservative fiscal policy.

The IMF includes countries like Canada, the U.S., Russia, Brazil, India, China and Australia that have no desire to get caught up in the European mess. These countries will insist that the EMU countries guarantee the debt. At the moment, IMF leadership is in a state of turmoil, though that is a different story.

If EMU members don’t guarantee the debt, the IMF won’t lend and Greece defaults. This may lead to contagion where Ireland and Portugal also default to reduce their debt burden. Spain and Italy may follow. Widespread sovereign debt defaults will cause the euro to fall against the US dollar, Sterling, Swiss Francs and the Yen. A depreciation of the euro causes the price of oil in Europe to rise, which may lead to recession and inflation. An increase in European interest rates will tame inflation but further reduce growth.

The prediction: The IMF will call the EMU’s bluff and not extend further credit to Greece without a guarantee. Germany, Finland and Netherlands will not budge. Greece will put in motion a restructuring of their debt. Rating agencies will restate their position that Greece is defaulting. The euro will come under selling pressure. Germany will capitulate and guarantee the debt. The IMF will extend credit. Rating agencies will downgrade German sovereign debt.

Of course, all this depends on the river card.