Justin Wiltshire 301114994 Opinion Paper 2: The downfall of the Euro

Econ 402 Nov 17, 2011

It is likely than anyone with even a half-hearted interest in political economy has been paying attention to the crisis which has been growing in Europe over the past two years. Yields on the debt of the so-called PIIGS (Portugal, Italy, Ireland, Spain, and Greece) have crept up beyond sustainable levels, pushing those countries ever closer to bankruptcy. Banks in nearly all Euro-zone countries (which share a common currency with the PIIGS) are heavily exposed to the debt issued by these threatened countries, through both the direct holding of PIIGS debt and because of the many financial instruments (such as credit default swaps) which they have issued as insurance against the threat of these nations defaulting. Even one disorderly default would fell many of these institutions, and would severely cripple those that managed to survive. Those Euro-zone countries not presently threatened directly would nonetheless find their financial systems in ruins. Observers such as The Economist, who now see this outcome as very likely1, have noted repeatedly as the crisis has built that the member countries (particularly Germany and France) could have taken decisive steps to contain it2, but have instead continually offered too little, too late to calm bond markets. Given the devastating consequences these countries face if this all comes to pass, one is left wondering: why have they allowed it to get this bad? The answer, as I have modeled it, is that the sizes of the rescue packages which have been offered have not been large enough to signal to bond market investors that Euro-zone member countries are committed to saving the Euro if default should seem imminent for one of the PIIGS. Since bond markets are composed of many investors, most of whom can neither communicate nor commit to act in particular way, they require assurance that the bond-issuers will not default. To the degree they dont have this assurance, these largely risk-averse investors require greater yields to compensate them for the risk they assume by holding those bonds. I have modeled this situation as a signaling game in which Euro-zone member countries (EMCs) or not very committed to saving the Euro. Though all EMCs prefer to are either highly committed save the Euro, the political sentiments of the electorate in EMCs can have effects on the actions of their elected representatives. Bond market investors cannot tell the true commitment level of EMCs, but obviously prefer . EMCs can help troubled members by offering bailouts of size which cost , , such that , > , , > 0, and > 0. will be perceived by bond markets and will yield a corresponding probability of bond market stability , (When = 100%, investors will definitely not sell off their bonds. When = 0%, investors will dump their bonds for sure). Given the lines. corresponding , investors have a constant expected return which is equal along both 0 1, and , > , for all > 0. Investors know that EMCs have utility functions 1 = if they are , and 1 = if they are . >0 and
1 2

of

< 0. Investors also know

> 0 and

> 0,

http://www.economist.com/blogs/freeexchange/2011/11/euro-crisis-8 th rd Three years to save the Euro, The Economist, April 17 -23 2010

and that these indifference curves for highly committed and not very committed EMCs intersect. If this resulted in a separating equilibrium, investors would be able to tell when they observed = , and could act such that = > = . Unfortunately they do not result in a separating equilibrium, since = , > , = . That is, investors know that EMCs will want to offer = so as to suggest to investors that they are really in the hopes of receiving , . EMCs seem to have hoped that bond market investors would not recognize that results in a pooling equilibriumbut they have. Since investors know this, they cannot distinguish between and when they observe , so they assume and offer = ( , < , which is the worst case scenario for both and when = . If EMCs are truly , as they say they are, they should have offered to properly assure bond markets ( = yields the highest utility). Its true that = , < , = , but it was actually attainable since = , > , = (that is, it would have resulted in a separating equilibrium because EMCs would not have offered s*). Since < is all that has been offered, investors have reasonably intuited that EMCs are not very committed to saving the Euro. EMCs unwillingness to offer despite the damaging consequences is likely a result of disagreements between individual EMCs (who may actually differ in their individual . Accounting for the successively larger S we have seen in each bailout package is easy: we simply assume that, as time passes, very possibly be the collapse of the Euro. become flatter (
,

< 0 where =

). The result will