The prisoner's dilemma could well be applied to the Eurozone these days. For those not familiar with it, a brief introduction is in order: The prisoner's dilemma is a concept in game theory which suggests the following scenario where people cooperating would likely do well for themselves, but they might not do so anyway:
The police arrest two people for a crime but they don't have enough evidence on either of them to hold them for the crime they committed (say armed robbery). They do have evidence for a lesser charge though (for example, possession of an illegal firearm). The two men are separated and offered the chance to testify against the other. If only one agrees to testify, then that one will go free while the other will get 10 years in prison. If both testify against each other, they'll each get reduced sentences of three years in prison. If both of them stay quiet, they'll be prosecuted under the lesser charge and both of them will get just one year in prison.
It would seem to make sense for both of them to stay quiet, however game theory suggests that it's more likely for the two of them to testify against each other because they are trying to gain the maximum advantage for themselves.
Germany Against Spain
No, it's not a World Cup match. Instead, this is the Eurozone and the issue now is that Spain, like Greece before it, is teetering on the brink of bankruptcy. It is estimated that Spanish banks are now holding around 80 billion euros worth of bad real estate loans which need to be written off and the rest of the Eurozone is looking into helping them because they realize that they need to solve this problem fast before Spain goes bust, which would effectively ruin the Euro.
The thing is, while everyone knows that it needs to be done, game theory is coming into play here and the Germans are trying to insist on more austerity measures in exchange for shoring up the Spanish government in much the same way that they did with Greece. However, as we have seen in Greece, when people are pushed too hard, they may well decide to take matters into their own hands.
The Drachma and Then the Peseta?
Many analysts now believe that Greece may reintroduce the Drachma following upcoming elections in that country on June 17. The question is, if Germany pushes the Spaniards too hard, will they abandon the Euro and decide to reintroduce the Peseta? It's a real possibility according murmurings from some major figures in the Eurozone, including Mario Draghi, the president of the European Central Bank. While the word peseta never crossed his lips, the implication of recent statements are clear – the Euro is facing a real chance of splitting apart at the seams, causing severe pain for all involved.
Game Theory Takes Over
Other analysts are however predicting (and indeed, I have suggested much the same in previous columns in this space) that even with the situation as dire as it is, the Euro can be saved and will be saved by efforts to implement a monetary union similar to that of the United States, where a European version of the Federal Reserve may be created. Other measures being looked at include the possibility of issuing Euro bonds and or the possibility of creating some kind of unifying agency which will enforce budgeting across the Euro zone. The question is, even though these things would ultimately benefit all of Europe, will the Prisoner's dilemma and game theory take over, causing an ultimate crash and a worsening of the situation all around?
My Thoughts
I'd like to believe that Europe's leaders are smart enough to understand that their future is now inextricably bound together and that this means they'll do what they must to allow the Euro to survive. However, at this time, I'm suggesting that it may not be wise to hold long term debt in shaky Eurozone economies, especially Spain, given that the situation is so fraught with danger. As to the Forex market, my suggestion is to short the Euro in the short term, perhaps even against the dollar, which has been gaining value steadily against the European currency. Long term, I wouldn't risk anything in the Euro zone right now because it's still too difficult to see what the future holds.