It is in everyone’s economic interest, both short and long-term, to solve theUkrainian crisis; and therefore they will – or, at least, that is what rational thinking would suggest. But the reality is very different. And it is not necessarily because the parties involved in this crisis are irrational. Rather, it is because they are stuck in what game theorists call a “prisoners’ dilemma”. In the process, the risks of adverse global economic spillovers are on the rise.
The recent escalation of events in Ukraine has narrowed the set of options available to the four major parties involved – the country itself, Russia, central and western Europe and the US. As this occurs, the probability of each party attaining its desired outcome is rapidly declining, let alone them retaining sufficient control over developments on the ground. Indeed, the current course is one that leads to growing internal Ukrainian fragmentation, biting western sanctions on Russia, counter-sanctions by Moscow on western energy supplies, and a mounting financial bill for all.
The result would be economically and financially harmful to all, albeit to different degrees.
Ukraine would suffer the most, risking a deep economic implosion and full-blown financial crisis. In the process it would become even more highly dependent – and for many more years – on external financial assistance, and all the inevitable conditionality that comes with that.
Russia would experience a pronounced economic contraction coupled with high inflation, capital flight and a collapse in foreign direct investment. (Only on Friday Russia’s credit rating was cut to just one notch above junk level, and the central bank was forced to raise interest rates to counter capital outflows and currency pressures.) Moreover, depending on the severity and sector-focus of prospective western sanctions – specifically, whether the financial sector is targeted – Russia could also find it harder to make international debt payments and open trade letters of credit.
Assuming Russia retaliates by imposing its own sanctions – its most likely response to stiff western measures – the resulting disruption in oil supplies would tip western Europe into recession. With neither a healing US or a stabilising emerging world able to compensate fully, the global economywould most likely be tipped into a recession too.
Since it is both in the collective and individual economic interest of all to avoid such a combination of outcomes, it would be reasonable to expect that the major parties would come together to iterate to a better place. Moreover, they still have the means and time to do so. Yet based on the robust insights of game theory – the most instructive framework for analysing the current situation – the probability of this happening is declining, slowly approaching real uncomfortable levels.
Game theorists call this a “prisoners’ dilemma” – no single party can force an outcome on the others. But rather than pursue outcomes that are in the collective and individual interests, each party is forced by initial conditions to opt for suboptimal results relative to what is theoretically possible.
The reasons for this are essentially threefold: insufficient trust among the parties; inadequate infrastructure for enabling internal co-operation and follow-up enforcement; and the absence of a forceful outside party able to provide credible validation, assessment and process accountability. Only a major disruption dislodges the initial conditions that force the suboptimal outcomes.
Applied to today’s Ukraine, this approach points to a material increase in the tail risk of global economic contagion. Western central banks would, of course, do all they can to counter the negative economic repercussions if the damage was no longer contained within Ukraine. But they would struggle to counter a supply shock of that magnitude, particularly given the amount of policy ammunition they have already used to help with the recovery from the global financial crisis.
There is still time for all parties involved to realise what is at stake and return to serious negotiations. But the clock is getting closer to midnight; and conditions on the ground are getting harder to control. The more markets recognise this – as they have started to do – the greater the risk that they would also contribute to an accelerated déroulement that is in one’s short or long-term interest.
Mohamed El-Erian is the former chief executive and co-chief investment officer of Pimco