Draghi & Rajoy in Game of Chicken

“Pass the chicken, Mario.”

Draghi May See Silver Lining in Disappointing Investors – Bloomberg.

This is the problem. The Bundesbank and German public opinion are against bailouts, and the ECB must mollify these important constituents. While Draghi seemingly has no qualms about firing up the printing press to bailout Europe, harsh conditions must be attached to these bailouts so that these countries are not seen as getting something for nothing. They also must undergo harsh reforms so that the public can see an end to the bailout cycle.

The Spanish people have been following the news, and they have witnessed the economic depression in Greece and the humiliation of Greek people by the troika of the ECB, IMF and EU. Prime Minister Rajoy must know that his goverment and political career will not survive a humiliating bailout with troika inspections and German domineering.

The relative positions that each side must take in this scenario lead to a game of chicken between Draghi and Rajoy. It is true that Spain needs a bailout, but it is also true that the troika needs Spain to be bailed out. Spain is just too large to fail. While people are beginning to believe that Greece could default and exit the Eurozone with very little consequence ( BTW, I do not agree that  a Grexit would be harmless), everyone knows that a Spanish default or exit would destroy the Eurozone.

This situation reminds me of the onset of World War I. After the Archduke was assassinated, the European powers coalesced around their two alliance systems. Each side mistakenly thought that the other would not go to war over some Serbian mischief; therefore, neither side backed down with catastrophic consequences.

Right now, I could see  ECB President Draghi sipping espresso in his Brussels office thinking to himself, “All I have to do is wait. It is obvious to everyone that Spain is almost broke, and they will need to request assistance soon. There is no way that they will shoot themselves in the head over a few conditions when delaying the bailout could mean a default.”

Then, I imagine Spanish Prime Minister Rajoy relaxing in the Palacia de la Moncloa with his cafe con leche musing, “I have the ECB right where I want them. There is no way they will allow my country to default when this will precipitate the breakup of the Eurozone. Once one country leaves, everyone will have an incentive to leave earlier than the next guy, and the ECB will never let this happen over a few bailout conditions.”

In poker, when two players think that the other is bluffing, there is a winner-take-all showdown for the pot. In this showdown, however, there will be no winners, just losers. If neither side budges, Spain will default. This default will either be de jure or a de facto default where bondholders are paid back in pesetas rather than the euros that they were promised. This default will mark the beginning of the end of the euro as the contagion spreads to the next weak country.

Let’s hope that the Europeans have learned something since World War I and are able to craft a face-saving solution that both sides can live with.

 

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