Negotiating the Third Greek Bailout: A Signalling Game with Double-Sided Incomplete Information

In Spring 2014, Greek Prime Minister Samaras asked Chancellor Merkel to start debt talks in line with promises made by the Eurogroup in November 2012. However, she turned down Samaras’ offer. For many commentators, this decision was made to keep leverage on the likely coming new Greek government, and signal that any challenge to the status quo will cause financial support to stop. This analysis misses an important part of the story though. Refusing Samaras’ offer endogenously reinforced the momentum for Tsipras as debt relief was critical for Samaras’ political survival. Puzzlingly, Merkel had significant political leeway to (quietly) discuss with Samaras while negotiating with Tsipras, under the scrutiny of a very critical public opinion, could have entailed significant audience costs for Merkel. Eventually, the deal reached on the brink of Grexit was therefore extremely costly for Merkel as an important share of her backbenchers challenged her authority, the IMF refused to enter the program and the German public opinion was clearly dissatisfied with her management of the situation. So why did Merkel refuse to cooperate with Samaras in the first place? Using a signalling game-theoretical framework, we will show that double-sided incomplete information is a necessary condition for explaining the bargaining dynamics leading to the third Greek bailout. Even if both Germany (as representative of the creditor countries) and Greece were more Grexit-averse than compromise-averse, incomplete information about each other’s preferences ordering induced the players to take risks, exchange threats and escalate a conflict in order to make the opponent yield first.