Game Theoretic Modeling of Economic Systems and the European Debt Crisis

A game theoretic model of six kinds of players is analyzed, i.e. countries, central banks, banks, firms, households, and financial inter-governmental organizations. Each player has a strategy set, with strategies such as setting interest rates, lending, borrowing, producing, consuming, investing, importing, exporting, defaulting, and penalizing default. Markets for goods, debt, and capital are modeled endogenously. This conceptualization of strategic opportunities for as many as six types of players is richer than anything that has been attempted earlier. 2005–2011 empirical data for Greece is used to analyze how utility is impacted by public consumption and lump sum transfers, and negative productivity shocks, and to analyze equilibrium over several time periods with and without the possibility of default. 2007–2008 empirical data for Greece and Germany is used to determine how the two countries’ utilities depend on Greece’s public 2007 consumption, with and without negative productivity shocks. Greece’s high debt burden is shown to make default optimal when productivity shocks are large and the default penalty is small. We find that Germany has limited ability, through its available strategies, to prevent a Greek default, and may need to resort to unconventional tools such as debt forgiveness and changing the default penalty.