ITALY´S AND GERMANY´S ENDGAME FOR THE EURO / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

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July 12, 2012, 4:22 p.m. ET
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Italy and Germany's Endgame for the Euro
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By SIMON NIXON




Feeling more relaxed about the euro crisis since last month's summit? Think again. The risk of a euro-zone breakup may actually be rising rather than falling, according to Bank of America Merrill Lynch strategists David Woo and Athanasios Vamvakidis. Using game theory to consider how the situation might evolve, they believe the crisis will boil down to a game of bluff between Italy and Germany in which neither country has an incentive to back down.

Eidon Press/Zuma Press

Italian Prime Minister Mario Monti hosting a meeting with German Chancellor Angela Merkel in Rome earlier this month.

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That doesn't mean this would be the best outcome for either side; in game theory, the most likely outcome isn't always what economists call "Pareto optimal," one that will bring maximum benefit to all players. Instead, the "Nash equilibrium" for the euro zone—the situation in which no player has an incentive to change strategy because to do so unilaterally would leave them worse off—is that Italy refuses to undertake the overhauls needed to enable its economy to grow and Germany refuses to provide the bailouts to persuade it to stay.

To reach this conclusion, Messrs. Woo and Vamvakidis undertook a simple cost-benefit analysis for each of the euro zone's 17 members. This looked at which countries were best-placed for an orderly exit in terms of the size of their fiscal and current-account positions. They also looked at the likely impact of an exit on growth, borrowing costs and national balance sheets.



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The results make interesting reading: Italy and Ireland emerge as the countries with the greatest incentive to exit. In Italy's case, this is because it already runs a budget surplus before interest payments and has only a small current-account deficit. At the same time, its companies have the most to gain from devaluation. Surprisingly, the country with least incentive to exit is Germany since the cost-benefit analysis suggests a soaring currency would lead to lower growth, higher borrowing costs and big losses on overseas balances.




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If this is right, then the euro crisis boils down to a simple calculation: Is Germany willing to pay to keep Italy in the euro zone? Game theory says "no," say Messrs. Woo and Vamvakidis. The problem is that even if Germany did pay, Italy would still have a strong incentive to exit eventually rather than undertake overhauls, leaving Germany worse off. And if Italy knows Germany will never pay to keep Italy in the euro, it is in Italy's interest to exit. This is a higher stakes version of the Greek impasse over the last two years, except that Italy has more reasons to leave and the euro zone faces a bigger bill to persuade Italy to stay.




Does that make a euro breakup inevitable? Not necessarily. In the real world, the game is complicated by history and politics. This analysis may not fully capture the true costs of a breakup for all countries.





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For the moment, there is little political pressure in Italy to exit the euro. Besides, one thing could decisively alter the equation, say Messrs. Woo and Vamvakidis: A much weaker euro would significantly reduce the incentive of any country to exit. One way or another, policy makers are likely to bring that about.




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