"Game Theory and Crowded Trades"

From Prudent Bear (July 13):

It was, to say the least, another interesting week.  JP Morgan restated its first quarter earnings, as the company’s “London Whale” synthetic derivative loss jumped to $5.8bn.  Another city in California can’t pay its bills and readies for bankruptcy.  China reported second quarter growth at 7.6%, a three-year low, while articles abound questioning the veracity of Chinese data.  Moody’s downgraded Italy’s sovereign debt rating two notches to not much better than junk.  Apparently, Silvio Berlesconi is preparing for another run at the Italian presidency, as the competent Mario Monti states he’s not interested. Spain’s fledgling President Rajoy announced yet another austerity plan, this time hoping to trim a (stubbornly) huge budget deficit by $80bn.  

From my perspective, the most meaningful of this week’s data was Friday’s report from the ECB showing that Spanish bank borrowings had reached a record 337bn euro ($411bn), up almost 50bn euros ($61bn) during June.  Spanish institutions have now increased ECB borrowings by 204bn euro ($250bn) in only five months.  There’s no mystery surrounding President Rajoy’s snappy acquiescence to EU demands for additional painful deficit-cutting measures.  Spain’s banking system is suffering a run on deposits and liquidity.  The euro traded to two-year lows Friday morning, before rallying somewhat to close out another losing week.  

From Friday’s WSJ Heard on the Street column (Simon Nixon):  “Feeling more relaxed about the euro crisis since last month's summit? Think again. The risk of a euro-zone breakup may actually be rising rather than falling, according to Bank of America Merrill Lynch strategists David Woo and Athanasios Vamvakidis. Using game theory to consider how the situation might evolve, they believe the crisis will boil down to a game of bluff between Italy and Germany in which neither country has an incentive to back down.  That doesn't mean this would be the best outcome for either side; in game theory, the most likely outcome isn't always what economists call ‘Pareto optimal,’ one that will bring maximum benefit to all players. Instead, the ‘Nash equilibrium’ for the euro zone—the situation in which no player has an incentive to change strategy because to do so unilaterally would leave them worse off—is that Italy refuses to undertake the overhauls needed to enable its economy to grow and Germany refuses to provide the bailouts to persuade it to stay.”

From Wikipedia:  “It is commonly accepted that outcomes that are not Pareto efficient are to be avoided, and therefore Pareto efficiency is an important criterion for evaluating economic systems and public policies. If economic allocation in any system is not Pareto efficient, there is potential for a Pareto improvement—an increase in Pareto efficiency: through reallocation, improvements can be made to at least one participant's well-being without reducing any other participant's well-being.  …In practice, ensuring that nobody is disadvantaged by a change aimed at achieving Pareto efficiency may require compensation of one or more parties. For instance, if a change in economic policy eliminates a monopoly and that market subsequently becomes competitive and more efficient, the monopolist will be made worse off…  This means the monopolist can be compensated for its loss while still leaving a net gain for others in the economy, a Pareto improvement. In real-world practice, such compensations have unintended consequences. They can lead to incentive distortions over time as agents anticipate such compensations and change their actions accordingly.”....MORE