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Game Over for Euro? Theory Predicts Gloom

Tuesday, 10 Jul 2012 | 4:48 PM ET
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The countries with the least to lose from leaving the euro aren't the ones you think - and that could be bad news for the euro.

Think the euro zone will break up? Hardly anyone else does either, at least not after that European Union summit.

David Woo, head of global rates and currency research at Bank of America Merrill Lynch, has looked at the euro zone through the lens of game theory, and he begs to differ.

"Everybody more or less assumes that worse comes to worst, we’ll wind up with eurobonds," Woo told CNBC.com. "That simply is not an accurate representation of the political or economic considerations on the table right now."

Woo has looked at the economic situation in each of the eleven largest euro zone countries, and assessed the likely impact of a euro zone exit on their balance sheets, borrowing costs, growth, and political stability.

The conventional wisdom on Wall Street is that strong countries like Germany and Austria could leave the euro zone without too much trauma, while the weaker peripheral countries need the stability of the euro.

But Woo added up the impact of an exit on the eleven countries, and found that "Italy and Ireland have the highest relative incentive to voluntarily exit the euro, by our analysis." Conversely, "while Germany is the country most likely to achieve an orderly exit from the euro, it also has the lowest incentive of any country to leave."

That doesn't mean the lira is on its way back, Woo says. But "the point is this: Italy has a stronger incentive to leave the euro zone than Greece, then Italy will be less likely to accept tough conditionalities to stay."

Plenty of investors believe that even if incentives differ, the euro zone will hang together because it's to the member countries' collective advantage. But here again, Woo disagrees.

Woo went back to the prisoner's dilemma - that old chestnut of a problem in which individuals' own incentives override their joint interests - and looked at what Germany and Greece might do about eurobonds and austerity. It would be in both countries' interests to cooperate - for Greece to adopt austerity and Germany to agree to eurobonds.

But each country will ultimately decide on its own path, and Greece would be better off with eurobonds but no austerity, while Germany would benefit more from the opposite. A formula for compromise? Not exactly.

All this leads Woo to a gloomy view on the euro. His firm's official forecast is for the euro to hit 1.20 in the next six months. But because his tactical analysis shows that countries have so many incentives not to cooperate on resolving the crisis, Woo told me he sees a 40 percent chance that the euro will touch 1.10 during that time.

"The market," he says, "may be too complacent."

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