The US fiscal cliff negotiations are running down to the wire. Surprising? No. Simple models from game theory suggest we’re heading for the edge.
The term “fiscal cliff” refers to a collection of mammoth tax increases and spending cuts that are due to come into effect in early 2013. The measures imply a significant contraction in government spending, which commentators are worried would send the US economy back into recession. A bad thing for the world, not just American’s. Good summary pieces to look at on what exactly the fiscal cliff is include this CFR piece and the BBC Q&A.
The cliff has been likened to a game of chicken, an important model of conflict from game theory. This model captures the idea that neither party wants to be the one to back down, although the worst possible outcome occurs when neither yields. Although “chicken” goes some way towards representing the current situation, it omits some key features that suggest we’re going over the edge.
The game of chicken has its origins in a game where two drivers speed towards each other on a collision course destined for death and destruction. This terrible fate can only be averted if one driver swerves and accepts the (socially crippling) shame of being labeled “a chicken”. The simple game alone does not tell us which party will duck out: there are multiple “Nash equilibria”. However, restricting ourselves to consider “pure strategies” only (i.e. as a driver I can either choose to swerve or not serve), then the equilibrium outcome is for one party to backdown and be labeled a chicken. In our case, this would amount to one party conceding to the other’s fiscal demands and crisis being averted at the last minute.
Yet, the chicken analogy, although helpful, does not go far enough. Let’s take the car example. Imagine you’re a driver involved. Before starting the face off, you’d really like to give your opponent a look and say: “Just so you know, there’s no way I’m backing down. So matey, swerve.” However, this threat isn’t credible. You’re opponent would be silly to believe you. Conditional on my opponent staying the course, it’s best for me to duck out and face poultry related stigma.
However, I could take actions before getting into the car to make my not-swerving-claims credible. Take a look at the film “Footloose” to get the idea (no, really do look at this scene: Kevin Bacon driving a tractor with Bonnie Tyler playing in the background). In the film, a dare results in two teenagers playing a game of chicken. The boy played by Kevin Bacon ends up winning, not because of any braveness on his part, but because a tangled shoe lace prevents him from bailing. Knowing that Bacon is unable to get off the tractor, his opponent ducks out. An example that shows greater foresight rather than just lazy shoelace tying, is that of Hernan Cortes, who scuttled his ships during the conquest of Mexico in 1519 to prevent his soldiers deserting. The key idea is that you can limit your action set ex ante to put you in a better bargaining position. Applied to the fiscal cliff, one can argue that the Republican party’s claims regarding inability to compromise are credible. Given the current make up of the House, legislation implying tax rises for the wealthy is a no go here. The fanatical element of the Republican party thus lends their claims weight. Taken alone, this suggests compromise on the Democratic side.
However, another difference between the current situation and the simple model is that falling off the cliff doesn’t necessarily represent the worst outcome for Democrats (although, to be sure it would be bad). If this is true, then off the cliff we go. In fact, they are making parachute/landing preparations. More negotiations will follow if agreement is not reached this weekend. We are operating in a repeated game context, not the “one-shot” scenario in a chicken world. Thus, the cliff metaphor isn’t really accurate. A better one would be a really-difficult mogul-ski-course (although, granted, this isn’t super catchy). Once over the cliff, the “status quo” point will be different: taxes will be higher across the board and spending slashed. On the tax front, Democrats will be in a more favorable bargaining position as they will be rooting for lower taxes for certain portions of society. It is likely to be easier to muster Republican support for such measures. However, to be sure, this strategy is risky. The Republican party will still have the bias towards inflexibility and lack of compromise, but, arguably, the ill that can come of this will be more salient, giving Democrats greater room to poke the pointy stick of public opinion at their opponents in the next round.
Therefore, in my opinion, it looks like the US is going over the cliff. The Republican’s are not going to yield and the Democrats could potentially do worse. A game of lemming rather than chicken seems more apt.
PS Footloose link.