Tag Archives: game theory

Is Euro Zone Cohesion at Risk?(Blog7)

The win out of the leftist party Syriza in the Greek election seems to intensify the disturbance of Eurozone’s break up. As described in a Jan, 25 WSJ’s article written by Simon Nixon: “Over the coming weeks, it must strike a deal with a new radical left-wing government in Greece that it will likely find even more unpalatable – or watch Greece leave the eurozone with potentially disastrous consequences for the whole currency bloc.” (http://www.wsj.com/articles/greek-election-tests-eurozone-cohesion-1422222267?tesla=y&mod=WSJ_hp_LEFTTopStories)

However, personally I think the situation is quite clear for Greece. Either quit the euro zone and start a new currency, or reach a compromise in terms of the fiscal austerity plan with ECB, EU and IMF, and keep its membership in the euro zone. ECB president Mario Draghi once said: “a monetary union of 19 sovereign countries can only work if the citizens of each member state believe that they are better off inside the euro zone than out.” It is just like in a game theory, and Greece’s leave is a threat. Whether the threat will works depends on whether it is a credible threat. And whether it could becomes a credible threat depends on who will be hit harder once Greece quit the euro zone.

From Greece’s prospect:

Once leaving the euro zone, it will faces at least following problems:

1.The new government has to issue new currency, which will require a lot of time and effort.

2. Due to Greece’ debt problem, the value of the new currency would be depreciate, which will causes a series consequences such as deposit flight and inflation in domestic, and losing credit for external.

There are also some goodness if Greece leave the euro zone. The first and the most important is that it can get rid of its fiscal austerity plan forced by EU and make its local financial and fiscal policies more flexible.

On the other hand, the advantage of staying in euro is that they can still get aid from its neighbors as well as all the membership advantages such as free trade and no currency exchange fee. While the disadvantages of the staying is that Greece will still have to be under the pressure and restrictions, as well as suffering the gloomy prospective of euro.

From Other EU countries’ prospect:

Though different countries hold different idea, but Greece’s leave is definitely a bed idea. First of all, the value of bond or asset they hold from Greece would shrink dramatically due to the depreciation. They would also lose the benefit of no-barrier Greece market. More importantly, the exit of Greece would lead a chaos on Euro Union which is seen as a backward of the Union.

And I am afraid that the only benefit other EU countries could get from Greece’s exit would be an increase in their “safe-haven asset” or hedge fund.

I could highly simplify the problem into the following game theory table:

Other EU    ,      Greece Stay Quit
Stay     (8,10)    (-1, 1)
Quit Highly impossible Highly impossible

And if Greece is rational enough, it will not take the Quit action since it will hit the Union and itself both though Union would be hit harder. By the way, the number in the above table would change depends on the compromise conditions the Union and Greece reach finally. As well as whether Greece is a crazy man if it want to spare no effort to hurt the Euro Union. But personally I don’t think Greece will take extreme move and leave the Euro zone.




What the SNB Teaches Us About Off Equilibrium Threats

One explanation for why the SNB went off the exchange rate peg was because its balance sheet was becoming too large. Even though balance sheet losses at central banks should have no theoretical effect on policy, Tyler Cowen argues that they do matter because balance sheet considerations serve as a political limit to how far central banks can go in their interventions.

The SNB’s failure to maintain their exchange rate peg can give us some insight into why unconventional monetary policy at the zero lower bound can be so difficult. In particular, it shows that the “off equilibrium threats” that are required to make monetary policy effective at the zero lower bound might be too large for central banks to stomach.

Apriori, it’s hard to imagine why central bank asset purchases can fail to push prices and output around. In Bernanke’s criticism of the Bank of Japan, he noted that if it were the case that domestic prices didn’t change in response to asset purchases, then the central bank could buy up the entire stock of domestic assets! In the limit, this would mean that the central bank could fund unlimited transfer payments. If that were really the case. This is patently absurd — supply side constraints realize themselves eventually—and so by contradiction it must be that at some point the central bank must be able to affect prices, and that in particular it can realize any arbitrarily high price level.

The international macro version of this argument is that a central bank must always be able to depreciate its own currency because otherwise, the central bank could buy up the entire global stock of assets.

But these results are only asymptotic. For any finite asset purchase, there’s no guarantee that the central bank will have an effect. And therein lies the problem. The frictions that balance sheet policies exploit are small, and the central bank needs to be able to commit to extremely large asset purchasesto have a large enough direct effect. To the extent that smaller purchases can have an effect, the only way they do so by operating on the expectations of future policies.

To formalize this, imagine that the central bank and foreign investors are playing a game. The central bank can choose between small interventions and large interventions, whereas the foreign investors can choose between going long the currency (and thus causing it to appreciate) or going short the currency (and thus causing it to depreciate).

If the central bank does a large intervention while foreign investors go long, the central bank can inflict infinite pain by buying up all of their real assets. In the end, all of the world’s assets would have been acquired while the foreign investors sit on piles of useless paper. However, this causes the central bank to suffer any political costs that come along with mass asset purchases.

So the central bank might want to do a small intervention. But if it’s not large enough, and expectations for inflation and exchange rates do not change, then foreign investors can continue going long the currency and thereby limiting the effect of monetary policy.

The central bank is in a dilemma. While it would prefer a small intervention, it needs to be willing to threaten a large intervention, or else foreign investors would not budge. But if political constraints are large enough, then the threat will not be credible and small interventions will have limited effect. For the central bank to ensure that the small intervention — short the currency world to be an equilibrium, it needs to have a credible “off equilibrium” threat that the central bank will buy up the world in the case that foreign investors do not short the currency as the central bank desires.

The conclusion is that when the SNB abandoned its peg, it lost its credibility to enforce these off equilibrium threats. This does not bode well for its future attempts at monetary policy at the zero lower bound.