Economic Chicken vs. Mutually Assured Destruction

While working in my garden this weekend I was thinking about a game of economic chicken. I was not the only one.

Economic Disconnect was writing about Superfund Strong Arm and a Game of Chicken.

Right now we are looking at a systemic banking crisis. The FED had to cut rates in a hurry, the discount window was open for business, Hank Paulson is running around on TV, in interviews, at any conference anywhere pushing the SIV Superfund. All these things are very rare and disquieting. The banks second front in their "War on Insolvency" is a game of chicken played against the FED, the US government, and the US taxpayer.

Let's play chicken.

The game of Chicken models two drivers, both headed for a single lane bridge from opposite directions. The first to swerve away yields the bridge to the other. If neither player swerves, the result is a costly deadlock in the middle of the bridge, or a potentially fatal head-on collision.

It is presumed that the best thing for each driver is to stay straight while the other swerves (since the other is the "chicken" while a crash is avoided). Additionally, a crash is presumed to be the worst outcome for both players. This yields a situation where each player, in attempting to secure his best outcome, risks the worse.

Payoff Chart in Chicken

The chart at the left shows what happens if neither person swerves. The result if no one swerves is a head on collision where both parties both likely die. One person usually swerves.

In practice both typically swerve at the last possible moment. If either person misjudges the other (or the speed of their own reactions), then two people die unless the other swerves hard enough and fast enough to compensate.

Is the ongoing game Mutually Assured Destruction (MAD) or is it Chicken? I suggest economic MAD is more like the game being played. All of the world's the central banks are involved as players. The current path is a massive economic failure at some point in the future. However, a peculiarity of the current game is that the first major player to "swerve" immediately causes his own demise as well as the demise of the other players.

For example, consider the threat by China to massively unload US treasuries. The threat is a hollow one. It is not in anyone's best interest to start a global credit crisis, but that is what would happen if foreign central banks start dumping treasuries in mass.

The same logic applies to players stuck in SIVs. Those who are not familiar with the SIV story, can read Enron Accounting at Citigroup, a Special Edition Five Things You Need to Know, and Marked to Fantasy to catch up.

In economic MAD, the first player to dump assets in a SIV immediately puts its own economic life at risk. More problematic is that it puts the entire system at risk. And so a phony plan to disguise the real worth of those assets is being put in place. As a stopgap, should someone sell, the SIV bailout plan is prepared to buy its own assets. Because that sounds preposterous (and it is), additional buyers of last resort are being sought.

Arm Twisting by Paulson

Paulson is now twisting arms internationally hoping to scrounge up support for his plan. Headlines last Friday stipulated SIV support grows.

"Paulson has done a short briefing on the SIV fund," Bank of Italy Governor Mario Draghi told journalists. "PIMCO and Fidelity have joined."

PIMCO's support comes as a surprise after Bill Gross, the chief investment officer of Pacific Investment Management Co. or PIMCO, criticized the effort as "a little lame" in a television interview.

A fire-sale of assets could lift borrowing costs globally, trigger big losses from investors and force banks to further write down some holdings on their balance sheets. Such sales could trigger huge losses for banks, and in the worst-case scenario tip the U.S. or Europe into recession.

Mario Draghi appears to be mistaken. MarketWatch is reporting "PIMCO is not participating" in the SIV bailout fund.

Player or not, Bill Gross' quip "a little lame" is an enormous understatement. The word "fraud" would be more appropriate.

It's important to remember the game we are in today is the price we paid for Greenspan's foolishness in slashing interest rates to 1% in the wake of the dotcom crash.

Greenspan did not make those rate cuts to prevent deflation. He made those cuts to bail out banks that made horrendously bad loans to dotcom companies and foreign banks. A side effect of the resultant credit bubble is that Greenspan has virtually guaranteed the deflation he claims to have prevented.

The problem with MAD is that we can pay a price today or a greater price in the future. At some point (perhaps it's starting now) there is no longer a choice. The day of reckoning comes when consumers are unwilling to borrow or banks are unwilling (or unable) to lend.

Because of the entanglement of $300 trillion to $500 trillion in derivatives (credit default swaps, options, and leveraged mortgage backed securities), the first player to swerve in a major way risks collapsing the system.

As in Global Thermonuclear War, "The only winning move is not to play." But it's far too late for that strategy now. Economic MAD has started, and there is no way to stop the game.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/