Yanis Varoufakis, the new Greek finance minister, is also an economist and an expert in game theory and co-author of Game Theory: a critical text. He is now putting theory into practice.
He wishes to renegotiate the terms of Greece’s debt repayments. He argues not that some of the debt should be written off, but that the terms of the repayment are far too tough.
Greece’s problem, he argues, was wrongly seen as one of a lack of liquidity and hence the Troika (of the EU, the ECB and the IMF) provided a large amount of loans to enable Greece to keep servicing its debts. These loans were conditional on Greece following austerity policies of higher taxes and reduced government expenditure. But this just compounded the problem as seen by Yanis Varoufakis. With a shrinking economy, it has been even more difficult to repay the loans granted by the Troika.
The problem, he argues, is essentially one of insolvency. The solution is to renegotiate the terms of the debt to make it possible to pay. This means reducing the size of the budget surplus that Greece is required to achieve. The Troika is currently demanding a surplus equal to 3% of GDP in 2015 and 4.5% of GDP in 2016.
The Syriza government is also seeking to link repayments to economic growth, by the issue of growth-linked bonds, whose interest rate depends on the rate of economic growth, with a zero rate if there is no growth in real GDP. He is also seeking emergency humanitarian aid
At the centre of the negotiations is a high stake game. On the one hand, Germany and other countries do not want to reduce Greece’s debts or soften their terms. The fear is that this could unleash demands from other highly indebted countries in the eurozone, such as Spain, Portugal and Ireland. Already, Podemos, Spain’s anti-austerity party is rapidly gaining support in Spain. On the other hand, the new Greek government cannot back down in its fundamental demands for easing the terms of its debt repayments.
And the threats on both sides are powerful. The Troika could demand that the original terms are met. If they are not, and Greece defaults, there could be capital flight from Greece (even more than now) and Greece could be forced from the euro. The Greeks would suffer from further falls in income, which would now be denominated in a weak drachma, high inflation and financial chaos. But that could unleash a wave of speculation against other weaker eurozone members and cause a break-up of the currency union. 
This could seriously harm all members and have large-scale repercussions for the global economy.
So neither side wants Greece to leave the euro. But is it a game of chicken, where if neither side backs down, ‘Grexit’ (Greek exit from the euro) will be the result? Yanis Varoufakis understands the dimensions of the ‘game’ very well. He is well aware of the quote from Keynes, ‘If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has.’ He will no doubt bring all his gaming skills to play in attempting to reach the best deal for Greece.
Greece’s last minute offer to Brussels changes absolutely nothing The Telegraph, Ambrose Evans-Pritchard (10/2/15)
The next card Yanis Varoufakis will play The Conversation, Partha Gangopadhyay (8/2/15)
Senior European official: ‘The Greeks are digging their own graves’ Business Insider, Mike Bird (10/2/15)
Greece: The Tie That Doesn’t Bind New York Times, Paul Krugman (9/2/15)
Greek finance minister says euro will collapse if Greece exits Reuters, Gavin Jones (8/2/15)
Greece is playing to lose the debt crisis poker game The Guardian, Project Syndicate and Anatole Kaletsky (9/2/15)
Greek markets find sliver of hope Financial Times, Elaine Moore, Kerin Hope and Daniel Dombey (10/2/15)
Greece: What are the options for its future? BBC News, Jamie Robertson (12/2/15)
‘If I weren’t scared, I’d be awfully dangerous’ The Guardian, Helena Smith (13/2/15)
Greek debt crisis: German MPs back bailout extension BBC News (27/2/15)
Questions
- Is a deal over the terms of repayment of Greek debt a zero sum game? Explain whether it is or not.
- What are Keynes Bisque bonds (or GDP-indexed bonds)? Do a Web search to find out whether they have been used and what their potential advantages and disadvantages are. Are they a good solution for both creditors and Greece in the current situation?
- What is meant by a ‘debt swap’? What forms can debt swaps take?
- Has Greece played its best cards too early?
- Should Greece insist on debt reduction and simply negotiate around the size and terms of that reduction?
- Are Greece’s new structural reform proposals likely to find favour with other EU countries and the Troika?
According to a report by the McKinsey Global Institute, global debt is now higher than before the financial crisis. And that crisis was largely caused by excessive lending. As The Telegraph article linked below states:
The figures are as remarkable as they are terrifying. Global debt – defined as the liabilities of governments, firms and households – has jumped by $57 trillion, or 17% of global GDP, since the fourth quarter of 2007, which was supposed to be the peak of the bad old credit-fuelled days. In 2000, total debt was worth 246% of global GDP; by 2007, this had risen to 269% of GDP and today we are at 286% of GDP.
This is not how policy since the financial crisis was supposed to have worked out. Central banks and governments have been trying to encourage greater saving and reduced credit as a percentage of 
GDP, a greater capital base for banks, and reduced government deficits as a means of reducing government debt. But of 47 large economies in the McKinsey study, only five have succeeded in reducing their debt/GDP ratios since 2007 and in many the ratio has got a lot higher. China, for example, has seen its debt to GDP ratio almost double – from 158% to 282%, although its government debt remains low relative to other major economies.
Part of the problem is that the lack of growth in many countries has made it hard for countries to reduce their public-sector deficits to levels that will allow the public-sector debt/GDP ratio to fall.
In terms of the UK, private-sector debt has been falling as a percentage of GDP. But this has been more than offset by a rise in the public-sector debt/GDP ratio. As Robert Peston says:
[UK indebtedness] increased by 30 percentage points, to 252% of GDP (excluding financial sector or City debts) – as government debts have jumped by 50 percentage points of GDP, while corporate and household debts have decreased by 12 and 8 percentage points of GDP respectively.
So what are the likely consequences of this growth in debt and what can be done about it? The articles and report consider these questions.
Articles
Instead of paying down its debts, the world’s gone on another credit binge The Telegraph, Allister Heath (5/2/15)
Global debts rise $57tn since crash BBC News, Robert Peston (5/2/15)
China’s Total Debt Load Equals 282% of GDP, Raising Economic Risks The Wall Street Journal, Pedro Nicolaci da Costa (4/2/15)
Report
Debt and (not much) deleveraging McKinsey Global Institute, Richard Dobbs, Susan Lund, Jonathan Woetzel, and Mina Mutafchieva (February 2015)
Questions
- Explain what is meant by ‘leverage’.
- Why does a low-leverage economy do better in a downturn than a high-leverage one?
- What is the relationship between deficits and the debt/GDP ratio?
- When might an increase in debt be good for an economy?
- Comment on the statement in The Telegraph article that ‘In theory, debt is fine if it is backed up by high-quality collateral’.
- Why does the rise is debt matter for the global economy?
- Is it possible for (a) individual countries; (b) all countries collectively to ‘live beyond their means’ by consuming more than they are producing through borrowing?
- What is the structure of China’s debt and what problems does this pose for the Chinese economy?
Newspaper headlines this week read that the UK’s balance of trade deficit has widened to £34.8bn, the largest since 2010. And when you exclude services, the trade in goods deficit, at £119.9bn is the largest ever in nominal terms and is also likely to be the largest as a percentage of GDP.
So far so bad. But when you look a little closer, the picture is more mixed. The balance of trade deficit (i.e. on both goods and services) narrowed each quarter of 2014, although the monthly figure did widen in December 2014. In fact the trade in goods deficit increased substantially in December from £9.3bn to £10.2bn.
At first sight the widening of the trade deficit in December might seem surprising, given the dramatic drop in oil prices. Surely, with demand for oil being relatively inelastic, a large cut in oil prices should significantly reduce the expenditure on oil? In fact the reverse happened. The oil deficit in December increased from £598m to £940m. The reason is that oil importing companies have been stockpiling oil while low prices persist. Clearly, this is in anticipation that oil prices will rise again before too long. What we have seen, therefore, is a demand that is elastic in the short run, even though it is relatively inelastic in the medium run.
But the trade deficit is still large. Even when you strip out oil, the deficit in December still rose – from £8.7bn to £9.2bn. There are two main reasons for this deterioration.
The first is a strong pound. The sterling exchange rate index rose by 1.8% in December and a further 0.4% in January. With quantitative easing pushing down the value of the euro and loose monetary policies in China and Australia pushing down the value of their currencies, sterling is set to appreciate further.
The second is continuing weakness in the eurozone and a slowing of growth in some major developing countries, including China. This will continue to dampen the growth in UK exports.
But what of the overall current account? Figures are at present available only up to 2014 Q3, but the picture is bleak (see the chart). As the ONS states:
The current account deficit widened in Q3 2014, to 6.0% of nominal Gross Domestic Product GDP, representing the joint largest deficit since Office for National Statistics (ONS) records began in 1955.
This deterioration in performance can be partly attributed to the recent weakness in the primary income balance [see]. This also reached a record deficit in Q3 2014 of 2.8% of nominal GDP; a figure that can be primarily attributed to a fall in UK residents’ earnings from investment abroad, and broadly stable foreign resident earnings on their investments in the UK
The primary income account captures income flows into and out of the UK economy, as opposed to current transfers (secondary income) from taxes, grants, etc. The large deficit reflects a decline in the holding by UK residents of foreign assets from 92% of GDP in 2008 to 67% by the end of 2014. This, in turn, reflects the poorer rate of return on many of these assets. By contrast, the holdings of UK assets by foreign residents has increased. They have been earning a higher rate of return on these assets than UK residents have on foreign assets. And so, despite UK interest rates having fallen, as the quote above says, foreign residents’ earnings on their holding of UK assets has remained broadly stable.
Articles
UK trade deficit last year widest since 2010 BBC News (6/2/15)
UK’s trade deficit widens to 2010 high as consumers take advantage of falling oil The Telegraph, Peter Spence (6/2/15)
UK trade deficit widens to four-year high The Guardian, Katie Allen (6/2/15)
UK trade deficit hits four-year high Financial Times, Ferdinando Giugliano (6/2/15)
Data
Balance of Payments ONS (topic link)
Summary: UK Trade, December 2014 ONS (6/2/15)
Current account, income balance and net international investment position ONS (23/1/15)
Pink Book – Tables ONS
Questions
- Distinguish between he current account, the capital account and the financial account of the balance of payments.
- If the overall balance of payments must, by definition, balance, why does it matter if the following are in deficit: (a) trade in goods; (b) the current account; (b) income flows?
- What would cause the balance of trade deficit to narrow?
- Discuss what policies the government could pursue to reduce the size of the current account deficit? Distinguish between demand-side and supply-side policies.
- Why has the sterling exchange rate index been appreciating in recent months?
- What do you think is likely to happen to the sterling exchange rate index in the coming months? Explain.
One effect of an expansionary monetary policy is a depreciation of the exchange rate. Take the case of countries using a combination of a reduction in central bank interest rates and quantitative easing (QE). A fall in interest rates will encourage an outflow of finance; and part of the money created through quantitative easing will be used to purchase foreign assets. Both create an increased demand for foreign currencies and drive down the exchange rate.
The latest case of expansionary monetary policy is that employed by the ECB. After months of promising to ‘do whatever it takes’ and taking various steps towards full QE, the ECB finally announced a large-scale QE programme on 22 January 2015.
With people increasingly predicting QE and with the ECB reducing interest rates, so the euro depreciated. Between March 2014 and 21 January 2015, the euro depreciated by 20.2% against the dollar and the euro exchange rate index depreciated by 9.7%. With the announced programme of QE being somewhat larger than markets expected, in the week following the announcement the euro fell a further 2.3% against the dollar, and the euro exchange rate index also fell by 2.3%. The euro is now at its lowest level against the US dollar since April 2003 (see chart).
The depreciation of the euro will be welcome news for eurozone exporters. It makes their exports cheaper in foreign currency terms and thus makes their exports more competitive. 
Similarly Japanese exporters were helped by the depreciation of the yen following the announcement on 31 October 2014 by the Bank of Japan of an increase in its own QE programme. The yen has depreciated by 7.7% against the dollar since then.
But every currency cannot depreciate against other currencies simultaneously. With any bilateral exchange rate, the depreciation of one currency represents an appreciation of the other. So just as the euro and yen have depreciated against the dollar, the dollar has appreciated against the euro and yen. This has made US goods less competitive relative to eurozone and Japanese goods.
The danger is that currency wars will result, with monetary policy being used in various countries to achieve competitive depreciations. Already, the Swiss have been forced, on 15 January, to remove the cap with the euro at SF1 – €0.833. Since then the Swiss franc has appreciated by some 15% to around SF1 – €0.96. Will the Swiss now be forced to relax their monetary policy?
The Danish and Canadian central banks have cut their interest rates, hoping to stem an appreciation of their currencies. On 28 January, the Monetary Authority of Singapore sold Singapore dollars to engineer a depreciation. The Singapore dollar duly fell by the most in over four years.
But are these policies simply beggar-my-neighbour policies? Is it a zero-sum game, where the gains to the countries with depreciating currencies are exactly offset by losses to the those with appreciating ones? Or is there a net gain from overall looser monetary policy at a time of sluggish growth? Or is there a net loss from greater currency volatility, which will create greater uncertainty and dampen cross-border investment? The following article explore the issues.
Articles
Massive Devaluation of the Euro Seeking Alpha, Sagar Joshi (26/1/15)
Devaluation and discord as the world’s currencies quietly go to war The Observer (25/1/15)
Why is dollar strong vs. 18 trillion of USA’s debt? Pravda, Lyuba Lulko (26/1/15)
Central Bankers Ramp Up Currency Wars Wall Street Journal, Anjani Trivedi, Josie Cox and Carolyn Cui (28/1/15)
The Raging Currency Wars Across Europe The Market Oracle, Gary_Dorsch (29/1/15)
Why ECB action is likely to stoke global currency wars Financial Times, Ralph Atkins (22/1/15)
Euro slides as ECB launches QE Financial Times (22/1/15)
Will Australia join the Currency Wars? The Daily Reckoning, Australia, Greg Canavan (23/1/15)
Australia’s central bank cuts rates to record low; currency plunges and stocks spike The Telegraph (3/2/15)
Singapore loosens monetary policy Financial Times, Jeremy Grant (28/1/15)
Currency Wars Have a Nuclear Option Bloomberg, Mark Gilbert (12/2/15)
Questions
- Explain how quantitative easing results in depreciation. What determines the size of the depreciation?
- How is the USA likely to react to an appreciation of the dollar?
- In the UK, who will benefit and who will lose from the depreciation of the euro?
- What are the global benefits and costs of a round of competitive depreciations?
- How does the size of the financial account of the balance of payments affect the size of a depreciation resulting from QE?
- What determines a country’s exchange-rate elasticity of demand for exports? How does this elasticity of demand affect the size of changes in the current account of the balance of payments following a depreciation?
- Might depreciation of their currencies reduce countries’ commitment to achieving structural reforms? Or might it ‘buy them time’ to allow them to introduce such reforms in a more carefully planned way and for such reforms to take effect? Discuss.
In a speech in Dublin on 28 January 2015, titled ‘Fortune favours the bold‘, Mark Carney, the Governor of the Bank of England, compared the UK economy to that of the 19-nation eurozone. While he welcomed the ECB’s recently announced quantitative easing programme, he argued that the current construction of the eurozone is unfinished and still has two fundamental weaknesses that have not been addressed.
The first is the fragmented nature of banking:
With limited cross-border banking in the euro area, savings don’t flow to potential investments. Euro-area corporates’ cash balances have risen to the tune of €420 billion, or 3% of GDP, since the crisis, for example. Modest cross-border equity flows mean inadequate risk sharing.
The second is the lack of an integrated fiscal policy.
For complete solutions to both current and potential future problems, the sharing of fiscal risks is required.
It is no coincidence that effective currency unions tend to have centralised fiscal authorities whose spending is a sizeable share of GDP – averaging over a quarter of GDP for advanced countries outside the euro area.
… If the eurozone were a country, fiscal policy would be substantially more supportive. However, it is tighter than in the UK, even though Europe still lacks other effective risk sharing mechanisms
and is relatively inflexible. A more constructive fiscal policy would help recycle surplus private savings and mitigate the tail risk of stagnation. It would also bridge the drag from structural reforms on nominal spending and would be consistent with the longer term direction of travel towards greater integration.
But fiscal integration requires a political will to transfer fiscal surpluses from the stronger countries, such as Germany, to the weaker countries, such as those in southern Europe.
Overall, the financial and fiscal position in the eurozone is strong:
Gross general government debt in the euro area is roughly the same as in the UK and below the average of advanced economies. The weighted average yield on 10-year euro area sovereign debt is around 1%, compared to 1½% in the UK. And yet, the euro area’s fiscal deficit is half that in the UK. Its structural deficit, according to the IMF, is less than one third as large.
But, unlike the UK, where, despite the rhetoric of austerity, automatic fiscal stabilisers have been allowed to work and the government has accepted a much slower than planned reduction in the deficit, in the eurozone fiscal policy remains tight. Yet unemployment, at 11½%, is twice the rate in the UK and economic growth, at around 0.7% is only one-quarter of that in the UK.
Without a eurozone-wide fiscal policy the problem of slow growth is likely to persist for some time. Monetary policy in the form of QE will help and structural reforms will help to stimulate potential output and long-term growth, but these policies could be much more effective if backed up by fiscal policy.
Whether they will be any time soon is a political question.
Speech
Fortune favours the bold Bank of England. Mark Carney (29/1/15)
Articles
Bank of England’s Carney urges Europe to take plunge on fiscal union Reuters, Padraic Halpin (28/1/15)
Bank Of England’s Mark Carney Attacks ‘Timid’ Eurozone Recovery Attempts Huffington Post, Jack Sommers (29/1/15)
BoE’s Mark Carney calls for common eurozone fiscal policies Financial Times, Ferdinando Giugliano (28/1/15)
Carney attacks German austerity BBC News, Robert Peston (28/1/15)
Bank of England governor attacks eurozone austerity The Guardian, Larry Elliott (28/1/15)
Questions
- Compare the financial and fiscal positions of the UK and the eurozone.
- In what way is there a ‘debt trap’ in the eurozone?
- What did Mark Carney mean when he said, ‘Cross-border risk-sharing through the financial system has slid backwards.’?
- What options are there for the eurozone sharing fiscal risks?
- What would a ‘more constructive’ fiscal policy, as advocated by Mark Carney, look like?
- How do the fiscal policies of other currency unions, such as the UK (union of the four nations of the UK) or the USA (union of the 50 states) or Canada (union of the 10 provinces and three territories), differ from that of the eurozone?
Yanis Varoufakis, the new Greek finance minister, is also an economist and an expert in game theory and co-author of Game Theory: a critical text. He is now putting theory into practice.
The Syriza government is also seeking to link repayments to economic growth, by the issue of growth-linked bonds, whose interest rate depends on the rate of economic growth, with a zero rate if there is no growth in real GDP. He is also seeking emergency humanitarian aid
