International debt in a signalling game

   The current discussion on the macroeconomic conditions, in particular public debt, of Portugal, Greece and Spain, is a heated one. Articles appearing in press have argued that Portugal is next to Greece in the spotlight of problems; at the same time, the Greek officials declare they are in a similar situation of Portugal and Spain. Portuguese officials deny it and declare the Portuguese economy to be totally different from the Greek.

   This parade of official statements and newspaper articles suddenly brought to my mind the setup of a signalling game: the Greeks want to pool with the Portuguese to get an "average" spread on their debt interest, while the Portuguese want to play the "good risk" type, and aim for a separating equilibrium, with a lower spread in their debt.

   The big question is whether international investors will settle for the pooling or for the separating equilibrium, and whether any credit rationing may appear in equilibrium to sort countries out.

   At this light, one should look for those commitments (and not only words) of the Portuguese Government that only a "good" type would make, without the higher risk country wanting to imitate. Looking at the Portuguese promises so far, if one would want to interpret the current measures as a signal, which ones would not be followed by Greece?

   Playing the "soft"card is tricky - saying that Portugal does not need to such hard measures as Greece does is what essentially is happening, but this relies in the absolute necessity of the Greeks to adopt the current hard measures. Still, does not preclude that if this signal works, then countries in trouble will refrain even further from adopting corrective, hard, measures in their economies. Adopting very harsh measures in Portugal could be read as a signal of trouble, as the countries with "bad types" need to take them as well, and pooling at the "bad" type may follow.

   So, an interesting question, at least to me, being largely ignorant in international monetary economics, is which measure would work as a credible signal, in the sense that only a country with relatively good conditions would take it?

   ps. I know I mostly ask questions, I am taking this blog as a learning tool :D