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Fred Bergsten and Jacob Kirkegaard Need to Read Thomas Schelling

- January 26, 2012

Fred Bergsten and Jacob Kirkegaard argue that there is nothing to worry about in the eurozone crisis.

bq. The economic and financial problems in the Eurozone are clearly serious and plentiful. The area is in the midst of multiple, frequently overlapping and mutually reinforcing crises. … We have complete confidence that, in the crunch, both Germany and the ECB will pay whatever is necessary to avert disaster. The ultimate political goals of each assure this result. … As the Greek government (with the rest of the Eurozone and the IMF looking over their shoulders) haggles with private creditors, and non-Eurozone members of the G20 consider whether to provide more resources to the IMF, the key actors in the crisis are still positioning themselves to force others to pick up as much of the crisis costs as possible. In the meantime, the crisis continues and may superficially appear to be insoluble. Yet, there are in fact several possible solutions to stave off a near-term meltdown when Italy and Spain begin their large bond rollovers in early 2012 … It remains to be seen which solution will be chosen. It is possible, indeed likely, that the ultimate package will combine parts of each of the above. …

bq. But it is obvious that none of these solutions are even remotely as costly for any of the main actors involved, inside or outside the Eurozone, as a sovereign default in Italy and/or collapse of the euro. That is why, once the political pre-positioning is over and the alternatives are exhausted, the games of chicken will end and the political decision on how to split the bill for securing the euro’s survival will be taken. Every policymaker in Europe knows that the collapse of the euro would be a political and economic disaster for all and thus totally unacceptable. Fortunately, Europe is an affluent region with ample resources to solve its crisis – it is a matter of establishing the political will to pay rather than the economic ability to pay.

This seems, on the surface, like a plausible argument – if everyone in a crisis bargaining situation recognizes that they face disaster in the case of breakdown then they will never get to the point of breakdown. But it isn’t actually all that plausible, for reasons that Thomas Schelling discussed in his classic book on nuclear deterrence, _Arms and Influence._ In the early 1960s, both the US and the Soviet Union faced obvious disaster if they actually got embroiled in an all-out nuclear war. But this didn’t stop them from engaging in brinkmanship – taking actions which went went right up to the edge of courting disaster in order to make gains. The problem is that one side’s just-on-the-boundaries-of-tolerable brinkmanship may be another’s over-the-edge-into-provocation-that-we-cannot-tolerate. As Schelling puts it in his analysis of the Cuban Missile Crisis:

bq. There is just no foreseeable route by which the United States and Soviet Union could become engaged in a major nuclear war. This does not mean that a nuclear war cannot occur. It only means that if it occurs it will result from a process that is not entirely foreseen, from reactions that are not fully predictable, from decisions that are not wholly deliberate, from events that are not fully under control. … There was nothing about the blockade of Cuba by American vessels that could have led straightforwardly into general war. Any _foreseeable_ course of events would have involved steps that the Soviets or the Americans – realizing that they would lead straightforwardly to general war – would not have taken. But the Soviets could be expected to take steps that, though not leading directly to war, could further compound risk … The Cuban crisis was a competition in risk taking, involving steps that would have made no sense if they led predictably and ineluctably to a major war, yet would also have made no sense if they were completely without danger … in such a crisis, the danger of inadvertent war goes up. This is why they are called “crises.” The essence of a crisis is its unpredictability.

Even if one accepts Bergsten and Kierkegaard’s claim that everyone genuinely realizes the risks of breakdown (I am not so sanguine myself), Schelling’s logic seems to me to capture the Eurozone crisis far better than their arguments. If all actors are willing to play chicken, risking irresolvable breakdown of the system, in order to get their way, then that poses an obvious risk of instability – an actor may go too far, and precipitate breakdown by accident. This risk is all the higher given the importance of market reactions in determining success or failure, and the inability to predict with even the faintest degree of confidence how markets might react to this or that move (it is clear from previous iterations of this game that the key political actors’ ability to model market reactions to their proposals is … limited). Given that Schelling was originally an economist (and eventually won the Nobel Prize for same), it is a bit surprising that his arguments about crisis bargaining are not better known among economists like Bergsten and Kirkegaard. Surely, they are difficult to formalize. But they provide a better, and unfortunately more unforgiving, lens on the current situation than overly optimistic assumptions about availability of information, ability of actors to recognize the risks of collapse and revise their strategies accordingly etc.