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.

The Varied Effects of Gasoline Prices

A recent article in the NY Times concerning the price of gasoline caught our attention because it touched on so many concepts related to the demand for gasoline. (Click here for article)

An increase in gasoline prices will cause different people to react in different ways. Some will be forced to pay the higher prices and cut down on their consumption of other goods. Others will be able to change their lifestyles and reduce their consumption of gasoline. One thing is certain; as the price of gasoline rises, people purchase less gasoline. The only question is, by how much?

Economists use the concept of elasticity to measure the responsiveness of consumer purchases to changes in price. Over relatively short periods of time, consumers can generally not react and we say that demand is inelastic, meaning unresponsive. The NY Times article quotes a MasterCard source that says consumption of gasoline has fallen by 1% over the last year. The US Energy Information Administration reports an increase in gasoline prices of 38% over the same period. The elasticity measure is (-)0.026, indicating an inelastic demand – consumers, in general, are not reducing their consumption of gasoline significantly.

When prices rise, and consumers continue to purchase gasoline, the consumption of other goods must fall. Consumers are worse off since the price increase reduces the purchasing power of their income. We should expect the demand for normal goods to fall and the demand for inferior goods to rise. There is evidence of this at the True Value hardware store, where sales of replacement parts (an inferior good) have increased.

Over longer periods of time, more consumers can change their consumption, and elasticity increases. People become more responsive to the price change. This is usually a result of people simply not being able to respond in the short run. A person with a 50-mile (80 km) round trip commute can change jobs, relocate, or purchase a small vehicle. None of these options may be possible in the short run. If gasoline prices remain high, we would expect to see the sales of smaller vehicles increase first and then perhaps see people moving closer to their place of employment. These are long run responses.

Consumers’ response to changing prices depends on whether or not they can easily change their spending patterns. In the short run they may not be able to change and thus the demand appears to be relatively inelastic. Over a longer period of time, if prices stay high, consumers will respond and demand becomes more elastic. Evidence of this behaviour can be found in this article.

© 2011 Pearson Canada Inc., All rights reserved, Used by permission

The Ace of Mortgages

I am upset that the federal government in Canada will not compensate me for losses when I go to the casino, and I hope that that seems like an unreasonable request. Residents and potential home buyers in upscale Monterey California are upset that the U.S. federal government will no long assume the downside risk on residential real estate in their area. This should also seem like an unreasonable request.

The issue was brought to light in a recent article in the NY Times. The federal government has reduced the maximum mortgage insurance amount in Monterey County to $483,000, well below the average selling price. This transfers the risk of housing prices onto home owners.

Mortgages can, and have been modelled as put options on real estate. Put options are more commonly understood in the context of equities, or stocks. A put option on Exxon shares gives the buyer (holder) the right to sell the Exxon shares at a predetermined price (the exercise price) prior to some preset date (the expiry date) and imposes an obligation on the seller (writer) of the option to purchase those Exxon shares. The writer is assuming some of the downside risk on the Exxon shares and the holder pays the writer a premium for assuming this risk. A put option is not unlike an insurance policy on a stock. The amount of the premium is related to the amount of time until expiry, the risk free interest rate and the probability that the price of the stock will fall to the exercise price – which depends on the difference between the current price of the stock and the exercise price, and the volatility of the stock price.

A home owner with a mortgage always has the option of defaulting on the mortgage, essentially selling the home back to the lender for the amount of the mortgage. The probability of a homeowner defaulting depends on the loan to value ratio and the interest rate. As housing prices fall, homeowners are more likely to default. Who bears the risk of a default depends on whether the mortgage is insured. If it is, the insurer bears the risk, if it is not insured, the mortgage holder bears the risk. This could be the initiating lender, the holder of a mortgage-backed security, or a government sponsored enterprise such as Fannie Mae or Freddie Mac.

Without government participation in the housing market, mortgage interest rates and down payments would be determined by a potential buyers income and credit score. Lower income and/or low credit scores would require higher down payments and higher interest rates to compensate the lender for the higher risk of default. This is not unlike the pricing of stock options. It is for this reason that Monterey County homeowners are upset. If the government will not assume their risk, they will be required to pay the higher option premium when there is higher risk.

For more information on options see the Chicago Board Options Exchange education center.

For more information on mortgages as put options, see the article by Ronel Elul in the FRSB of Philadelphia Business Review Q3 2006.

A River Runs Through It

Water is an interesting commodity. It is essential for human life, but less expensive than diamonds. Two thirds of the planet is covered with it and it is short supply. And almost everywhere, the ownership of water is not well defined. The first issue was dealt with by Adam Smith. The second has something to do with the difference between fresh water and salt water. The third has caused a lawsuit between Wyoming and Montana (and more strange comments from Sarah Palin). Stories can be found at Billings Gazette and CBS-Sacramento.

At issue is water that flows from the Big Horn Mountains of Wyoming, into the Tongue and Powder Rivers, through Montana where they join the Yellowstone River then the Missouri and Mississippi, before finally emptying into the Gulf of Mexico. The water is a common property, meaning there is no well-defined property right. If the people of Wyoming use the water, they impose a negative externality on their downstream neighbours. The Coase Theorem suggests that there is a market solution to such a problem.

In the case of Wyoming and Montana, Wyoming benefits from taking water out of the rivers before it gets to Montana and Montana benefits from Wyoming not taking water from the rivers. This suggests that Wyoming would be willing to compensate Montana for water it takes, and also suggests that Montana would be willing to compensate Wyoming for not taking water out of the rivers. Alternatively, the two states could negotiate a contract that stipulates how much water Wyoming can take from the rivers before it reaches Montana. This is exactly what happened in 1950 when the two states, along with North Dakota, signed the Yellowstone Compact allocating water rights.

Like so many agreements, however, the potential for technological change was not considered. In the 1950’s irrigation involved flooding fields. A large portion of the water used drained back into the river systems and was available for downstream use. The development of new technologies have reduced the amount of water required per acre of farmland and thus increased the net amount of water taken from the rivers, though not the gross amount. This was the issue of the lawsuit. The court found that the original agreement referred to gross, not net amounts and found in favour of Wyoming.

Having lost the case, Montana must now renegotiate with Wyoming for water and again, there is a market solution to the problem. Expect to see more of this type of litigation in the future where water rights are not well defined in a world of changing technology.

Sarah Palin's comments are the same issue, but between competing users in the same state.

On Low Voter Turnouts

Today is Election Day in Canada … again. With four main parties, and a host of fringe parties, we are going to the polls for the fourth time in 8 years. As in the last 4 elections, we can expect that, today, one out of every three eligible voters will choose not to exercise their right to vote. This begs the question of what, if anything can be done to increase voter turnout.

Journalists, political scientists, ethicists, psychologist, and other “experts” have tackled this question with no dominant strategy. The fail, we believe, because they don’t ask ‘why’ the electorate chooses not to vote. Once again, economists come to the rescue.

People are maximizers – one of the essential assumptions of economics. The implication of this is that an individual will undertake an action if they believe that the marginal benefit to them exceeds the marginal cost to them. When applied to elections, this means that an individual must believe that the benefit to them of casting a vote exceeds the opportunity cost of casting the vote. There are several other things that an individual can do with their time other than making their way to a polling station to cast an uninformed vote. An informed vote takes even longer and costs more.

In the riding where I reside, the incumbent won the last election by almost 7,000 votes, beating his closest opponent by 16.15 percentage points. I ask myself, ‘will my one vote change the outcome of this election?’ The answer is clearly ‘no’. Thus the marginal benefit to me of casting a vote is zero and the marginal cost is positive. The rational thing for me to do is not vote.

Some may argue that if enough people cast their votes, they could make a difference. This argument, however, requires that those that didn’t vote in the last election would have all voted for the same candidate. If the non-voters are randomly dispersed amongst all parties, then an increase in voter turnout does not change the outcome of the election.

If the economic argument is true, then there is nothing that can increase voter turnout in a meaningful way. Australia has made it mandatory to vote which increases the benefit of voting (avoiding the penalty for not voting). This method however is economically inefficient. You can force me to cast a ballot, by imposing a penalty, but since the ballots are secret, you cannot stop me from spoiling it. I will minimize my cost of voting by not becoming informed and spoiling the ballot. The law increases voter turnout, but not the legitimacy of the election.

So, Canadians, get out there today and vote … or don’t vote … but make your choice rationally.