As I started this blog about three years ago, the European debt crisis was taking off. At that time I did not expect the problems to become so grave and so enduring. Today, it seems almost hard to imagine that the crisis will end any time soon. The reason is, that – while there certainly has been some progress – the essential dynamic or problem is still the same: enforceability / credibility, or the lack thereof.
In one of the earliest articles here I analyzed the negotiations between Greece and Germany/EU in simple game theoretic terms. I think the analysis was in many ways correct and still applies. Put simply, what we observe is a game of chicken. All, or at least most, sides want to achieve a coordinated solution to the problem and prefer any such outcome (be it a fiscal union or status quo with bailouts) over chaos. However, there is substantial disagreement over which outcome is the desirable one, and that is at the heart of the problem.
It is a messy game. The way it is and has been played over the last years is brinkmanship. In nice regularity either the German government, the IMF, or occasionally the EU will claim that Greece (or any other country) will not receive the next bailout package in order to put pressure on Greece, while Greece does the opposite. Whoever swerves first loses. Simple.
At this point I do not see this cycle to be broken, which is sad as it creates immense uncertainty permeating the entire Eurozone to a degree which is entirely out of importance of the Greek economy. In that sense, an exit could be beneficial. However, a Greek exit is likely to put additional pressure on the other southern nations, at least for a couple of months, and it is unclear if that additional pressure could be sustained. In terms of balance sheets, a Greek exit, however, should by now be manageable and would primarily affect governments and public entities. Nevertheless, Greece staying within the union still seems more desirable. But this will require more effort by the Greek government.
Of course, Greece is not the only problem. Spain and potentially Italy are the bigger issues at the moment. In both cases, however, I believe that they have the capacity to get out of the crisis more or less on their own (at least in the sense of being able to repay bailout money at some point).
To “solve” the crisis, all important steps are known. Banks need to be recapitalized (finally!), national governments need to credibly commit to reduce their deficits over the medium run – constitutional debt brakes can do the trick, if the judiciary is strong enough -, structural reforms need to be enacted, existing expenses and investment schemes need to be thoroughly reviewed to eliminate wasteful spending. To enable these actions, short-term aid will be necessary, maybe even some degree of collectivized debt.
This might sound relatively easy, but again the problem is credibility. Financial aid, i.e. bailouts, needs to be given now, while all the true remedies will be carried out later. Hence, what economists call time inconsistency can arise: governments pledge reforms, get the money, forget about the reforms (and then need more money). The potential return of Berlusconi and the like is not helpful here. But I remain optimistic that Spain and Italy can create a credible commitment.
So, what do I expect for the next three years: first of all, no sudden solution. The underlying causes of the crisis go deep and will not be solved in months (especially since many national politicians have strong incentives not to do that). Instead we will continue to see this tit-for-tat strategy as it is the only rational one for playing this game in the absence of credibility or the ability to enforce deals. But many steps have been taken, particularly Spain is in the process of painfully reviewing its finances, but also Italy is moving in the right direction (also Ireland and Portugal seem on track). Greece might exit the Euro, but I still do not believe that it will happen. The crisis will probably not be entirely over in three years’ time, but hopefully we will see a growth in most European countries again as well as receding unemployment numbers.