February’s second 3-year LTRO looks set to be extremely large. Really extravagant claims (we have heard reports of €10 tn) are probably wide of the mark because this will not be a complete collateral free-for-all ... This is, on the face of it, very cheap protection indeed against any possibility of a liquidity crisis for three years.

A Nash equilibrium for the euro
Insights from Game Theory on the fate of the euro zone
It’s all about incentives

In A Nash equilibrium for Greece, we established the idea of using Game
Theory for analysing the Greek PSI programme. In this note, we extend the
concept to the broader euro zone debt crisis in order to explain its dynamics and
likely future path.

The continued existence of the euro will hugely depend on the incentive
structure of its members to defend it. In order to do so, costs must be
appreciated and allocated. We therefore demonstrate how:

• Incentives to deal with these costs are aligned only under certain conditions;
• An imbalance of incentives could lead to a euro breakup;
• Incentives evolve through time and interventions;
• Brinkmanship and threats are used as tools to improve either party’s outcome;
• Market stress is a logical and intended consequence; and
• Markets can be used as a mediator to improve each player’s outcome

Based on this Game Theory analysis, we see two scenarios for the future of the
euro:

1) A (catastrophic) breakup or (very expensive, probably catastrophic) exit of
at least one large member. We think this is possible but not likely. We
estimate the probability to be 10%-20%.

2) A long, painful and volatile continuation of the crisis that can only be
slowly improved by some type of inter European enforceable contract.

...

... the core player (who) wants to impose as large a portion
of the costs for the euro on the periphery by demanding more austerity while the periphery
player wants to allocate the costs away from itself, i.e., in the core...

... There are varied ways that costs could materialize. To mention just a few: inflation, bank
rescues and wind-downs and debt mutualisation. The first would likely impose losses on the
savers, particularly pensioners in the core as, if and when the ECB cuts rates further and
embarks on QE. Costs via the banking sector could materialize if more peripheral debt
losses would be imposed on the banks, which in turn would bring costs to the core via bank
guarantees, recapitalizations or even a reduction in lending activity to corporates and
households. Even a bank failure could be possible. Finally, debt mutualisation, for example,
via some sort of Eurobond, would impose costs on the core via higher borrowing rates.

The main method of enacting cost allocation to the periphery is via increased austerity and
labor market reforms. Most common examples include higher taxes, lower social benefits
and pension age increases...

... Given anemic growth in domestic demand, America’s only chance to move closer to its potential growth rate would be to reduce its large trade deficit. But net exports will be a drag on growth in 2012, for several reasons:

- The dollar would have to weaken further, which is unlikely, because many other central banks have followed the Federal Reserve in additional “quantitative easing,” with the euro likely to remain under downward pressure and China and other emerging-market countries still aggressively intervening to prevent their currencies from rising too fast.

- Slower growth in many advanced economies, China, and other emerging markets will mean lower demand for US exports.

- Oil prices are likely to remain elevated, given geopolitical risks in the Middle East, keeping the US energy-import bill high.

It is unlikely that US policy will come to the rescue. On the contrary, there will be a significant fiscal drag in 2012, and political gridlock in the run-up to the presidential election in November will prevent the authorities from addressing long-term fiscal issues...