November 18, 2011

Don’t call me a chicken!

Being called a chicken is never a good thing. You get called that in the schoolyard and the most likely thing to happen next is to hear humiliating laughs of the other mean kids. A movie character loses a game of “chicken”, and he is most likely losing the girl. That game has even been studied by game and signaling theory. 


The whole mess in Europe could be reduced to a game of chicken. Here, there are two cars being driven against each other, challenging each other not to veer to the side. One car is driven by Mario Draghi, the other one by the bond vigilantes (or speculators, as Europe’s politicians like to call them).

Signaling is paramount. Mario Draghi resists to monetize, and signals that the ECB will not openly use its balance sheet without restrictions to push sovereign rates down. The reason? The ECB –always mindful of its standing as a hawkish institution known as protector of the value of the Euro - risks denting its reputation of independence, which for any central bank that issues fiat currency is the most important intangible asset they have.

Draghi (under heavy skepticism) faces a lot of pressure from Germany not to monetize, also. The Germans know first hand how destructive hyperinflation can be, hence their uncompromising position against anything that could lead to the loss of confidence in the value of their currency. There are also the legal arguments of the ECB’s impossibility of buying sovereign paper (although this can be easily bypassed by a) making local banks swallow sovereign auctions and pledging the paper as collateral, or b) using the IMF as conduit --both of which mean monetization in the end). Finally, another reason to resist monetization is the political argument. Not ceding is an excellent way to push Italian/Greek/Spanish politicians to get serious about passing long overdue reforms to spur growth and reduce deficits.

On the other hand, you have the vigilantes/shorters/speculators (however you want to call them). Shorters will benefit from falls in prices which in turn precipitates the forced sale of sovereign papers by banks that need to clean their balance sheets in light of the new capitalization rules agreed to under the October Greek restructure deal. They have leverage, since their heavy selling makes their perception of sovereign bankruptcy a reality, which becomes self fulfilling, and that is a pretty powerful tool to make their position not to cede (to keep shorting) credible –of course, we know what happens to them if they fail and there’s a short squeeze.

Notwithstanding the structural, long term problems of the Eurozone, the short term problem is simply: Will Draghi finally cede and monetize? Or will he remain stoic about defending the Euro’s value and use shorters’ strength in his favor to force politicians to fix their budgets? Game theory says the game of chicken has 2 Nash equilibria (one cedes and the other one doesn’t and viceversa). So hypothetically, if no player knows what the other is going to play the outcome cannot be known. But, if one party knows the strategy the other is playing, that party chooses a strategy that maximizes its outcome. Here, Draghi has a disadvantage: this game already happened, and we know what each player chose to do in that game. Iterations in the game of chicken allow players to better guess what their counterpart will choose to play. Remember 2008? Paulson played the same game when he refused to bailout Lehman after having bailed out Bear Stearns in an attempt to make his threat credible. The result? Two rounds of QE, 310% increase in the size of the FED balance sheet ($7.7 trillion at its peak according to Bloomberg), and a long list whiners claiming that they have been hurt by the Dollar’s depreciation. Who wants some Pollo?

4/5/12 Update: 
With the introduction of the LTRO by the ECB, the winner of this game is now obvious. Like Paulson in 2008, Mr. Draghi has ceded.

1 comment:

  1. (typO on the original post, Chinonomist please delete previous)

    Great read.

    If it were up to me I'd let the "Italian/Greek/Spanish politicians" (sic) and any governments not willing to get their shit under control strangle to death (unilateraly cutting them out of any agreements/treaties beforehand, of course).

    I believe they got a bit overzealous in making the EU grow from the onset, somewhere along the line they forgot about creating a mechanism to FORCE member states to get their collective european shit together.