When strategy is mistaken for stupidity, the curious case of eurozone politicians

Have you ever ridden a bike to work in a major metropolitan city? If so, you’ll understand the importance of predictability. It’s best to stick to the cycle lanes, signal when turning, obey traffic signals, and not stop or swerve suddenly.

FT Alphaville wonders how many European politicians commute to the office this way. It would seem to be a good lesson on how predictability leads to positive outcomes and the importance of deciding which direction to go and then sticking to it.

Instead, Spain is swerving. France is posturing for less austerity and more policies to foster growth that will be funded by magic pixie dust the stuff of dreams an wealthy anonymous benefactor somehow. Greece is having another round of elections that are looking close to call, and Germany is seemingly against just about anything that would calm markets for more than a week.

All that said, enough with the politician bashing. Richard Barwell of RBS wishes to point out that policymakers aren’t idiots. They are rational actors acting on the basis of their particular ‘loss functions’. The behaviour dictated by those functions will determine the outcome of the crisis.

Sneak preview: sometimes cycling like a maniac is a good thing, particularly when riding a bike built like a Boris bike tank, because drivers may well take such a cyclist more seriously and get out of their way rather than the other way around. That is, for politicians, it can pay to have credible threats and engage in some reputation building.

From Barwell’s note published on Friday (emphasis ours):

Observation 2.) Policymakers are a lot smarter than you think

In the never ending commentary about the financial crisis that has engulfed Europe there is a groundswell of opinion that policymakers have failed, ‘don’t get it’, have consistently been ‘behind the curve’ and so on. (…)

Keeping in mind that policymakers are highly competent matters because it should make it easier to predict how, when and why policymakers will intervene. Rather than making a series of seemingly random mistakes policymakers are responding in a more systematic fashion according to some well defined – but not well understood – loss function within a set of constraints.

Or: it may seem that the crisis is being dealt with in a haphazard way, but that’s just because the motivations of politicians aren’t understood well enough. Time to get game theoretical:

Observation 3.) At the heart of the crisis is a non-cooperative game taking place between policymakers

(…)

None of these parties want to see a catastrophe scenario for Europe unfold because nobody profits from it. But beyond that there are a range of possible outcomes in which the crisis is resolved in different ways, with the surplus (the gain from avoiding the catastrophe) shared in different ways.

These parties are involved in repeated discussions (games) and we have to look for equilibrium strategies…

This leads to:

Observation 4.) .. Only credible threats carry weight in repeated games

But how does one build up credibility, and hence increase the chance of getting one’s way? Well…

Observation 5.) In an uncertain world, players will invest in a reputation

There is a still a missing piece of the jigsaw in this simple description of the game. It seems implausible to believe that each of the parties in this ‘game’ have a perfect understanding of the preferences (beliefs) of the other players. We can think of players Bayesian updating their priors about those beliefs, and hence the best response, of the fellow members of the game, and that in turn will shape the eventual equilibrium. Now we have a setting in which it is rational for a player in the dynamic game to make a costly investment in a reputation.

In particular, it could be beneficial for those representing either side in the game to take actions which look counter-productive in the short run in an attempt to convince the other players in the game that their preferences are more extreme than is actually the case, which in turn may lead the other players to rationally choose a strategy and therefore an equilibrium which favours the player who sought to build a reputation. Were these stratagems being played out in the current crisis it would not be a surprise for market participants to believe that policymakers somehow ‘didn’t get it’ or were ‘behind the curve’.

If this is true, then perhaps we should shortly expect some action from Germany — after all the time spent posturing to try to convince other players that they are so against eurozone bonds, for example. As for the influence of the electorate:

Observation 7.) Politicians will tend to reflect public opinion

(…)

Public choice economics suggests that any individual whose position depends on the support of the electorate will naturally tend towards promoting those policies which are perceived to benefit a sufficient proportion of their electorate to guarantee that they remain in post.

This true-ism is not an iron law. Not every politician will act like homo economicus – some may sacrifice their prospects of re-election to enact painful but necessary reforms. Others may try to shift public opinion towards their preferred position to increase their chances of survival.

Hence the potential advantage of having a technocratic government, at least in the short term. For the normal politicians though, it may not pay to stay in the bike lane. Instead acting like a maniac, provided one doesn’t get killed, may be optimal in order to ultimately get one’s way. They shouldn’t, however, expect everyone to understand the method behind the madness.

Related links:
Spain, Bankia and the credibility problem – FT Alphaville
Bankia, Spain, the ECB and a proliferation of “mistakes” - FT Alphaville
Panic has become all too rational - FT’s Martin Wolf
The riddle of German self-interest - FT’s Martin Wolf
Greek Game Theory: Default, Devaluation, Austerity, Deliverance? - The Daily Reckoning