Game Theory Expert Analyzes Fiscal Cliff, Predicts Its Outcome

Submitted on Friday, 12/7/2012, at 10:11 AM

It would seem that the so-called fiscal cliff showdown playing itself out in Washington, D.C., would be an excellent case study for the game theory course that Professor of Economics Christopher Kingston is teaching this semester at Amherst College.

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The term “fiscal cliff” itself refers to the effect of a number of laws which, if no agreement was reached, could result in tax increases, spending cuts and a corresponding reduction in the deficit beginning in 2013. These laws include tax increases due to the expiration of the Bush tax cuts, as well as spending cuts under the Budget Control Act of 2011.

But while the standoff does indeed fascinate Kingston, its usefulness as a teachable moment in a beginning game theory course is limited, he says, because the negotiation is very complex, with multiple uncertainties about the timeframe, the issues on the table and the motivations of the various players.

During a recent conversation with Amherst Public Affairs Director Peter Rooney, Kingston provided his perspective on the game of “chicken” that seems to be unfolding in Washington.

Q: If the fiscal cliff scenario is a game, some say that President Obama holds the upper hand. He argued for higher taxes for the wealthy during the campaign, he won the election, and therefore Republicans are in a weaker position as this game unfolds. Do you agree with that?

A: I think both sides know they are going to have to give; the question now is who’s going to give how much. The Democrats do seem to be in a stronger bargaining position. They won the election, and Obama doesn’t have to worry now about running for re-election again, whereas the Republicans are actually in a pretty weak position, in part because, by default, if there is no deal, there will be huge tax increases on Jan. 1 on everybody, including the top 2 percent, which is the real sticking point.

Q: Does history have any other examples of fiscal cliff scenarios that are intended to force compromise or agreement?

A: In game theory, these are known as “commitment devices”: sometimes, by binding your hands, you can paradoxically make yourself better off. One historical example is William the Conqueror, who, on landing in England, burned his ships behind him as a way to credibly convince his own soldiers and the enemy that he wasn’t going to retreat. In this case, the fiscal cliff includes a package of spending cuts that nobody wants to take effect, but they are essentially a way for the parties to try to bind their hands and force themselves to come up with some kind of deficit reduction agreement.

Q: Is there not also a whiff of “mutually assured destruction” to the fiscal cliff situation, especially if no action is taken?

A: I suppose my favorite example of that would be from the movie Dr. Strangelove. The Russians had this doomsday device: a nuclear weapon so destructive that if there were any nuclear war, the whole world would essentially be destroyed, blown up. There’s this sort of flavor to what’s going on here as well, because going over the fiscal cliff could send the economy back into a recession. But in fact it’s not as bad as that, in part because many of the impending changes are not irreversible, so even if we get past Jan. 1, probably a lot of the damage could be undone. Of course, the sooner they fix it, the better. But it’s hard to create a truly credible commitment device when you’re relying on a sort of artificial [device] like this.

Q: In the last couple of days, there have been articles and commentaries about the role that lobbyist Grover Norquist and his “no-tax pledge” that many Republican lawmakers have signed plays in this whole game. Do you see this as a complicating factor, or is this again something that is common in game theory?

A: I would say that the no-tax pledge is just another attempt at a commitment device, if the pledge is credible. By promising that you are not going to raise taxes, what you are attempting to do is pre-commit to a course of action.

Q: Do the Democrats have anything similar to a no-tax pledge that they’re using as a commitment device?

A: The president’s spokesman Jay Carney said the other day that the president will not sign, under any circumstances, an extension of tax cuts for the top 2 percent of American earners. Essentially, he’s trying to burn boats behind himself there as well, right? So the Republicans are trying to burn boats behind them by saying they are not going to raise taxes, they are not going to retreat, no surrender, no turning back. And the president and the Democrats are trying to do the same thing.

There’s a danger in that, because when they actually get in the room to negotiate, if everybody has made too many pledges of that sort, they may find that there’s no deal they can do anymore. But at the same time, it can strengthen your hand in negotiations if you make it costly to retreat from one of those positions by signing a pledge and so on. So this is all essentially posturing to try to strengthen their respective bargaining positions.

Q: It doesn’t seem as though much movement is being made in this game. Why is that, and do you have a prediction for a final result?

A: What we see in the current stalemate is both sides refusing to give ground and fighting a war of words, blaming the other side’s intransigence for the failure to reach a deal while also refusing to give much ground themselves.

Both sides are describing the other’s current proposals as “not serious,” and I think they’re both right: at this stage, it would not make sense for either side to make a proposal that involved a realistic compromise, as that would mean unilaterally giving up a lot of ground and would simply weaken your bargaining position when the serious negotiations get under way as the deadline approaches or passes. 

A more rational strategy is to initially stake out unrealistically hard-line initial positions and then give ground grudgingly in exchange for similar concessions from the other side. On the whole I still think the Republicans have a weaker bargaining position, because of the results of the election and the default scenario that taxes on everybody will increase on Jan. 1. The Republicans also seem more divided, which further weakens their bargaining power.

Q: So are you optimistic that a settlement will be reached before the Jan. 1 deadline?

A: It would clearly be better for the country that a deal be done and the uncertainty be resolved sooner rather than later, and to some extent that’s true for the politicians too. But the politicians also have an incentive to avoid making compromises until the last minute, or perhaps even until we are “over the cliff” in the New Year, in order to demonstrate to their supporters how strenuously they fought, how implacably they defended their ideals. For that reason, while I expect a deal will get done, I wouldn’t be surprised if a final deal wasn’t reached until after the Jan.1 deadline.