Game theory—in practice
February 17, 2015
from David Ruccio
Back when I taught Principles of Microeconomics, I offered a lecture or two on game theory. Given how terrible most textbook presentations are, I used to borrowed heavily from the work of Judith Mehta and Shaun Hargreaves-Heap and Yanis Varoufakis to explain the key assumptions behind and the tensions generated within game theory.
Now, Varoufakis is back—in a very different capacity, of course—to explain the lesson he learned from his studies of game theory:
The trouble with game theory, as I used to tell my students, is that it takes for granted the players’ motives. In poker or blackjack this assumption is unproblematic. But in the current deliberations between our European partners and Greece’s new government, the whole point is to forge new motives. To fashion a fresh mind-set that transcends national divides, dissolves the creditor-debtor distinction in favor of a pan-European perspective, and places the common European good above petty politics, dogma that proves toxic if universalized, and an us-versus-them mind-set.
And the payoff?
One may think that this retreat from game theory is motivated by some radical-left agenda. Not so. The major influence here is Immanuel Kant, the German philosopher who taught us that the rational and the free escape the empire of expediency by doing what is right.
How do we know that our modest policy agenda, which constitutes our red line, is right in Kant’s terms? We know by looking into the eyes of the hungry in the streets of our cities or contemplating our stressed middle class, or considering the interests of hard-working people in every European village and city within our monetary union. After all, Europe will only regain its soul when it regains the people’s trust by putting their interests center-stage.
*This is Bill O’Grady’s view of the payoff matrix of the “game” being played by Greece and the EU—as seen by the Syriza party.
Our view is that Syriza believes that caving in to the EU will end its political movement before it really begins. Caving in produces the outcome of -100 in quadrants one and three. Thus, its only positive payoff is to press for restructuring at all costs, while the EU caves (quadrant two outcome). At the same time, we think Tsipras believes that the costs to the EU of caving to Syriza aren’t all that high, but a situation in which both parties hold (quadrant four outcome), which probably entails a Greek exit from the Eurozone, is devastating for the EU. If the Eurozone breaks up, the Pandora Media Inc (NYSE:P)’s Box of European nationalism is released with all the risks that entails. The conditions that led to two world wars will return. And, most importantly, Germany loses its single currency free-trade zone. Thus, we fear that Syriza has concluded that the EU/Germany/ECB has no choice but to cave as long as Syriza holds firm.
Greece does battle with creationist economics: can Germany be brought into the 21st Century?
from Dean Baker
Europeans have been amused in recent weeks by the difficulty that Republican presidential candidates have with the theory of evolution. But these cognitive problems will only matter if one of these people gets into the White House and still finds himself unable to distinguish myth from reality. By contrast, Europe is already suffering enormous pain because the people setting economic policy prefer morality tales to economic reality.
This is the story of the confrontation between Greece and the leadership of the European Union. The northern European countries, most importantly Germany, insist on punishing Greece as a profligate spender. They insist on massive debt payments from Greece to the European Union and other official creditors to make up for excessive borrowing in prior years.
The current program requires that Greece’s tax revenues exceed non-interest government spending by 4.0 percent of GDP, the equivalent of $720 billion a year in the United States. This money is pulled out of Greece’s economy and sent to its creditors. Making matters worse, because Greece is locked into the euro at present, it is not able to regain competitiveness by lowering the value of its currency relative to the richer countries in Europe.
The result of the German program for Greece has been an economic downturn that makes the Great Depression in the United States look like a bad day. Seven years after the start of the downturn Greece’s economy is more than 23 percent smaller than its peak in 2007.
By comparison, at the trough of the Great Depression in 1933 the U.S. economy was 26 percent below its pre-recession peak in 1929, but it grew 10 percent the following year and had made up all the lost ground by 1936. On its current path Greece will be lucky if it returns to its pre-crash GDP by the middle of the next decade, twenty years after the crash.
The tales of hardship are endless: an unemployment rate of more than 25 percent, a youth unemployment rate of more than 50 percent, a collapsed health care system. The European Union folks may not know much economics, but they sure know how to destroy a country.
Interestingly, even their morality tale is at best half-true. Greece was a profligate spender, but what about punishing the reckless lenders? They were largely bailed out by the European Union, the International Monetary Fund and the European Central Bank, who now hold the vast majority of Greek debt. What about punishing Goldman Sachs, which designed the swap that allowed Greece to hide its debt so it could get into the euro in the first place?
Apparently the desire to punish sin only applies to the weak, not the rich and powerful who commit transgressions. The double standard is even clearer when applied to crisis countries like Spain and Ireland who had not been profligate borrowers. They had been running budget surpluses before the crisis. This was entirely a story of reckless lenders in Germany and elsewhere making bad loans to the private sector in these countries. Yet, the austerity policies being imposed ensure that the people of Spain and Ireland suffer even if the pain is not quite bad as in Greece.
The absurdity is that if the northern Europeans could get over their need to inflict pain, it would be easy to design policies which would allow the whole continent to benefit from more growth. If the deficit target for Greece was relaxed, it would be able to grow more rapidly. For example, assuming a multiplier of 1.5 (GDP grows one and a half times any increase in government spending), if Greece was required to run a primary budget surplus of 1.0 percent of GDP rather than 4.0 percent of GDP, its GDP could expand by 4.5 percent due to additional government spending. In fact, since the additional growth would lead to additional tax revenue, Greece’s economy would likely expand by more than 6.0 percent with this lower target.
The obvious complaint from the northern countries is that if Greece gets this concession other crisis countries will demand the same. That is correct, and they should get similar relief. The net effect will be much stronger growth in southern Europe, which will lead to increased demand and more growth in northern Europe as well. What exactly is the problem?
Since the crash, which incredibly caught all the economic “experts” by surprise, we have seen one myth after another destroyed by the evidence. Deficit reduction did not lead to a surge in investment due to increased confidence. Printing money in a badly depressed economy did not lead to runaway inflation or plunging currency values.
The time has come for the European Union to stop running economic policy based on silly myths. If German Chancellor Angela Merkel and other leaders in the European Union cannot accept reality then Greece and southern Europe would be far better off breaking free of the euro and leave Germany to wallow in its 19th century economic fairy tales.
Reforms in Greece. An exemplary record. But the wrong track. 3 graphs.
Greece is champion reformer. According to austerity mythology, we did not have a financial but a ‘rigidity’ crisis, aggravated by uncompetitive price levels. Which had to be solved with structural reforms and by bringing the price level (read: wages) down. Which is what Greece did, much more than any other country. But, as we do not have a rigidity crisis but a monetary crisis this did not work, of course. Some data: via Frances Coppola we learn that Greece has been the most ardent reformer of the entire Eurozone (graph 1, OECD data). Via Paul Krugman we learn that no country cut government expenditure as much as Greece (by a long shot: graph 2, Eurostat data). And Eurostat also teaches us that no country has been as succesful as Greece in lowering relative and even absolute prices (graph 3, Eurostat data). Coppola and Krugman are, understandable, aghast about the hypocrisy of the prime ministers of Ireland and Finland, who are lecturing Greece about something which it did much more succesfully than they did. And then there is the argument: “the Irish suffered for nothing, so the Greek have to suffer too“. Sigh.
Remark: the Krugman graph jpg has a lot of white below the actual graph.
Graph 1. OECD shows that Greece did reform
Graph 2. Krugman shows that Greece did cut government expenditure
Graph 3. Price data shows that the Greek relative price level declined much more than the Irish or the Baltic one