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Game Theory Reveals Terrible Strategic Thinking in Euroland

Sunday, October 30, 2011 22:43

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The following is an excerpt of an update sent to SK OptionTrader subscribers on October 25th 2011.

We hope that the publication of this excerpt can give non-subscribers an insight into how the SK OptionTrader service works and provide some explaination of the current situation in Europe.

“…we wish to take a moment to explain the situation in Europe since we have received a great deal of questions from subscribers asking for our thoughts on the situation. We are going to attempt to explain the situation by using game theory. We feel this is one of the best ways of understanding the fundamental forces at play.

Game theory is the heart of strategic thinking. Something that some people do well, and others not so well. The basics behind Game theory is that it includes a set of rules in which parties are trying to make strategic decisions, by which they may gain or lose, depending on the decisions made by the competing parties. Therefore the outcome of the game is determined by the strategies chosen by all participants.

In 1971 Mark Shubik invented a game called the dollar bill auction. This game involved bidding for a 1 dollar bill, the catch being that not only did the winner of the auction have to pay his bid amount, the runner up also had to pay his bid amount. For example if player X bid 98c and player Y bid 99c it is in player X’s best interests to bid $1 to avoid a 98c loss. However once this $1 bid is in place, player Y must bid $1.01 in order to lose 1c as opposed to 99c. From here it can never end well, and bidding will continue until players run out of resources or they make a decision to cut their losses. One option to avoid this terrible outcome is not entering the game at all, however the ideal outcome would be forming a partnership between all bidders and having one person bid 1c. Therefore instead of a bidding war in which everyone losses, the bidders gain the maximum profit of 99c. This situation is an example of the Nash Equilibrium.

You may ask what this has to do with the market environment? Well, the dollar bill auction is very similar to how the European debt crisis, in particular how the PIIGS have been dealt with. Since May 2010 Europe has been following a policy of doubling down each time their situation deteriorated. It started with Europe trying to save Greece in order to prevent the problems from spreading to Ireland and Portugal. After that failed to work, in August the EU decided to save Ireland, Portugal and provide more funding to Greece to try and stop the problems spreading further. Again this failed to stop these problems from getting worse so in early 2011 the EU started buying Italian and Spanish bonds in addition to buying more Portuguese, Irish and Greek bonds in order to stem the negative flow further throughout the EU. In July 2011, the EU increased the effort to save Italy, Spain, Portugal, Ireland and Greece so the problem would not spread to the banks. Now, in October, the banks are failing, therefore they need to save the banks and Italy, Spain, Ireland and Greece in order to save the world.

Up to this point the EU has done everything wrong from a strategic perspective. They have entered into a game where the best possible outcome vanished when the original funding for Greece did not stem the flow of their problems. However now that they are so far into the game, the best strategic move would be to cease all funding. Even if the EU does believe they have enough money to outbid the problems they are facing, their losses will only continue to increase if they continue this lose/lose game.

Therefore the proper strategy for the EU would be to resign from trying to keep Greece afloat and simply let it default. Then let Portugal and Ireland negotiate substantial cuts to their debt. And then finally, let the weakest banks fail. After this series of events has taken place, the EU should enter to provide support and liquidity. After this restructuring has taken place, then there is a strong case for providing a multi-trillion dollar firewall package to ensure a global financial meltdown is not possible. That would be better use of their funds, instead of continuing to give money to Greece, which is simply throwing good money after bad.

By the EU continuing along the current path, short term pain will continue to be avoided. However, the next time the EU is in trouble, the market will hit lower lows and they will have fewer tools to combat an even larger problem than they do now.

What one should take away from this is to never enter games like the dollar bill auction. Translated to the Eurozone this means never bail out failing institutions, whether they are private corporations or sovereign nations. Let them fail. Then perhaps provide support for the financial system, not for individual participants in the system. Any other course of action creates a moral hazard and leads to greater potential losses in the longer term.”

Our view is that the response from European policy makers will create some exciting trading opportunities. To receive our market updates and trading signals you can sign up to SK OptionTrader by clicking one of the buttons below.

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