Gaming Brexit

Benjamin Lavine, CFA, CAIA

Source: Published 7/8/2016

“The prisoner’s dilemma is a paradox in decision analysis in which two individuals acting in their own self-interests do not result in the optimal outcome. The typical prisoner’s dilemma is set up in such a way that both parties choose to protect themselves at the expense of the other participant. As a result of following a purely logical thought process, both participants find themselves in a worse state than if they had cooperated with each other in the decision-making process.”

– Will Kenton, 7/5/2018,

“Marriage is a prisoner’s dilemma in which you get to choose the person with whom you’re in cahoots. This might seem like a small change, but it potentially has a big effect on the structure of the game you’re playing. If you knew that, for some reason, your partner in crime would be miserable if you weren’t around – the kind of misery even a million dollars couldn’t cure – then you’d worry much less about them defecting and leaving you rot in jail.”

– Acclaimed author Brian Christian and cognitive scientist Tom Griffiths

Slowly but surely we may be witnessing the end of Brexit – the long, drawn-out divorce between the United Kingdom (U.K.) and the European Union (EU) 

On January 29, the U.K. Parliament passed the Brady Amendment to remove from the Brexit plan the Irish backstop – a provision that could effectively lock the U.K. into a permanent customs union with the EU.

The EU quickly responded that the backstop is not up for renegotiation. Still, U.K. sterling and equities rallied as investors expected some movement on the negotiation front – as neither the U.K. nor the EU relish the prospect of a ‘hard’ Brexit come the end of March. 

From the article, PM Theresa May “pledged to return to the Commons and put a revised deal – if she can get one…”, with a new deadline of February 13.    

We’re publishing this brief Brexit update in response to a recent article, “Game Theory Says Don’t Bet Against a No-Deal Brexit,” published by Leonid Bershidsky, European opinion columnist for Bloomberg. Bershidsky is skeptical the EU will agree to a deal that excludes the Irish backstop, because the EU is playing a different game than the U.K. (more on that later).

If both sides were acting rationally, they would see the mutually-assured destructive outcome of a hard Brexit. Keep in mind, for instance, that the U.K. runs a large trade deficit with Germany. Just as in the Prisoner’s Dilemma, “always defecting is still the fail-safe strategy for both players, but cooperation makes more sense…[however,] Repetition makes it possible that the other side…will cooperate and a mutually beneficial pattern will emerge.”

In other words, it is in neither party’s interest to continue to play chicken with each other until both parties drive off the hard Brexit cliff. However, what the Brexit aftermath has revealed is that the U.K. is the more miserable spouse in its marriage with the EU and has a greater incentive to ‘rot in jail’ rather than ‘cooperate’. 

Back in July 2016 following the Brexit vote, we published a payoff matrix that helped explain the rationale for why the majority of British voters opted to ‘Leave’ rather than ‘Remain.’ We surmised that both the U.K. and EU held asymmetrical payoffs believing that Brexit would produce more harmful outcomes to the opposing party. Although not a pure Prisoner’s Dilemma setup, the $2 payoff to the British was the same regardless of whether the EU would cooperate or not on renegotiating a new arrangement that addressed British voter concerns.

The EU also saw a similar $2 payoff on ‘cooperating’ with the U.K. regardless of whether the U.K. left the EU or not. Neither side had an incentive to cooperate. Hence, Parliament approved the Brexit referendum to be decided by the voters – and not surprisingly, the Leave camp prevailed.   

While Bershidksy more or less confirms our payoff scenario, he thinks a hard Brexit is more likely: beyond the scope of the EU/U.K.’s future trading relationship, the EU is worried that cooperating with the U.K. on the backstop could open the floodgate to other member defections. He writes:

“Instead, [the EU is] playing an infinitely repeated prisoner’s dilemma. The other player in this game is not the U.K. but any member state. It doesn’t end with Brexit: After the U.K., other countries (we don’t know how many, so the game is played as an infinite one) may be tempted to seek an EU exit on favorable terms, that is, keeping the trade benefits but not following lots of common rules. In such a game, always defecting is still the fail-safe strategy for both players, but cooperation makes more sense (and occurs more frequently in experiments) than in the one-off prisoner’s dilemma: Repetition makes it possible that the other side, too, will cooperate and a mutually beneficial pattern will emerge. [Underline emphasis 3D].”

Bershidsky makes a strong point. Still, we believe he underestimates the incentives for other member states to remain in the EU:

  • The more problematic member states with high debt loads and weaker economies – Italy, Spain, Portugal – benefit from lower sovereign credit costs due to monetary support from the European Central Bank; as well as the stronger credit profiles of the northern member states, particularly Germany.
  • #1 also extends to currency stability: Imagine Italy and Greece trying to sustain the living conditions of its citizens while paying for imports valued in liras and drachmas
  • Freer movement of capital and labor across member states means lower frictional costs.
  • Brexit may cause EU member states to push back against the overbearing regulatory authority of Brussels on local market activity, like dictating to restaurants what containers to use to store olive oil. This could engender some goodwill with the local citizenry.      

Perhaps, the EU will soon face its existential moment: is it a free trade association among cooperating member states, or a federal governing body that decides both monetary and fiscal policies for its member states? Those advocating for ‘Brexit’ prefer the former. Those opposing ‘Brexit’ believe that ultimately a suprarnational entity should govern the EU in order to interact effectively with major world powers such as the U.S., China, and Russia. 

Regardless, we believe the costs for a hard Brexit are too high for both parties, even if the EU is playing a different game than the U.K. For now, the market seems to agree that some agreement will be reached, avoiding the hard Brexit scenario. The rest of the first quarter should remain interesting for European investors.

The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of January 30, 2019, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailingsales@3dadvisor.comor visiting 3D’s website

By: Benjamin Lavine