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Brinkmanship and the Euro: Still a Bad Idea

- February 15, 2012

The _Financial Times_ “suggests”:http://www.ft.com/intl/cms/s/0/cf397bb8-5003-11e1-8c9a-00144feabdc0.html that brinkmanship in the eurozone may lead to catastrophe.

bq. Eurozone officials are deliberately refusing to allow Greece to sign off on a €200bn bond restructuring plan because the threat of default is the leverage they have to convince recalcitrant Greek ministers to implement necessary cuts. While some recognise that Greek politicians must be seen by voters to be putting up a fight, there are fears that the show of brinkmanship could easily go too far and backfire, with disastrous consequences.

This speaks directly to an argument that I’ve been having with Jacob Kirkegaard, who recommends brinkmanship as a “highly effective doctrine of policymaking”:http://www.piie.com/realtime/?p=2674 for the Peterson Institute, apparently in response to a post where I suggested that he needed to “brush up on Thomas Schelling”:http://tmc.org/blog/2012/01/26/fred-bergsten-and-jacob-kierkegaard-need-to-read-thomas-schelling/ (while Kirkegaard doesn’t cite or link my post, perhaps because PIIE house style forbids external links to mere blogs, he is surely responding to its main argument, and trying to assimilate it into his own).

Kirkegaard’s argument:

Many readers will undoubtedly say that this is a hopelessly optimistic scenario. It obviously requires many coordinated actions by many actors in a short time. The reason for this author’s optimism now and in the past stems from a belief in a highly effective doctrine of policymaking—”brinkmanship.” … Thomas Schelling, in his 1966 classic Arms and Influence (page 99) describes [brinkmanship] as “manipulating the shared risk of war” and “exploiting the danger that somebody may inadvertently go over the brink, dragging the other with him.” Brinkmanship is risky, but consider Schelling’s comments on page 96:

The essence of the crisis is its unpredictability. The ‘crisis’ that is confidently believed to involve no danger of things getting out of hand is no crisis; no matter how energetic the activity, as long as things are believed to be safe there is no crisis. And a ‘crisis’ that is known to entail disaster or large losses, or great changes of some sort that are completely foreseeable, is also no crisis; it is over as soon as it begins, there is no suspense. It is the essence of a crisis that the participants are not fully in control of events; they take steps and make decisions that raise or lower the danger, but in a realm of risk and uncertainty.

Schelling’s words certainly evoke the euro area crisis so far. Take the ill-timed and ill-conceived imposition of a debt write-down on Greek private creditors in July 2011, which unleashed a host of adverse developments unforeseen by the German policymakers who pushed hardest for it. The biggest of these was the market contagion to Spain and Italy, which European leaders are now scrambling to reverse.

The risk of accidentally triggering a “nuclear war outcome” that Schelling cited in his analysis of the Cuban Missile Crisis does exist in the euro area crisis, where a collapse of the euro could happen in spite of everyone’s best intentions. But the Cuban missile crisis analogy should not be taken too far. The US naval blockade did avert disaster in 1962. But even if euro area policymakers miscalculated by imposing PSI without a firewall in place first, the euro has survived even as the cost of bringing the euro crisis to an end and the size of the required firewall have gone up, as discussed above.

Engaging in brinkmanship to compel the Greek political elite to reform is not likely to produce a catastrophe. Rather the risks entail a higher cost of achieving ultimate reform. Note also that brinkmanship had some positive benefits. Had there been no Greek PSI and no associated contagion to Spain and Italy, Silvio Berlusconi would likely still be prime minister of Italy!

This seems to me to be a very badly mistaken reading of Schelling. If one plays Russian Roulette a few times, and wins, it is no very great cause for self-congratulation, let alone for recommending that we should do another few rounds since it seems to have worked out grand on the first few goes. Kirkegaard fudges the problem when he describes catastrophe as “not likely” and goes on to claim that the risks merely entail a “higher cost of achieving ultimate reform.” But surely – as the Schelling quote that he uses suggests – the possibility of catastrophe is always present.

The literature on brinkmanship agrees with Kirkegaard that brinkmanship can get results. It can force actors to make concessions that they otherwise would not make. But this is the problem, not the solution. It is _impossible_ to separate out the strategic (in a loose sense of the word) benefits of brinkmanship, from the possible catastrophe that actors are trying to leverage to increase their bargaining strength. If the risk of catastrophe were as tiny as Kirkegaard claims it is, then brinkmanship would _not_ be attractive. As Branislav Slantchev puts it in a very useful overview:

bq. Obviously, these are very dangerous tactics; they would not work unless they were dangerous because it is the generation of risk that makes them potentially worthwhile.

There is a fundamental internal contradiction in Kirkegaard’s argument. You can’t simultaneously claim that we are in that happy world where we can effectively disregard the possibility of disaster, and tell us that actors are using brinkmanship to convince Greece that it needs to undertake internal reforms. Either we are in a world where there _is_ a real risk of disaster, which is what allows Germany and northern European states to engage in brinkmanship. Or we are in a world without such a risk, in which case there is no space for brinkmanship. You can’t have your theoretical cake and eat it too.

The FT article suggests that we are in the first of these worlds – one where there is a real risk of breakdown, and where the northern members of the EU are trying their damnedest to use this as leverage against the Greeks. This might possibly produce reforms – but only through taking very high risks indeed. Kirkegaard’s alternative reading is, unfortunately, logically incoherent.