Game Theory and the Fiscal Cliff

In this recent article by the Globe and Mail, writer Andrew Steele analyzes the upcoming Fiscal Cliff through the game theoretic perspective. The game is "chicken". Two players face off, each faces a pay-off matrix such that whoever backs down leads to a negative outcome, and mutual refusal to back down leads to a mutually undesired outcome. The players are the Democratic and the Republican party, and their refusals are over the policies to take to avoid a fiscal cliff.

Fiscal cliff is the popular term describing the budget problems that faces the United States as the year 2012 comes to an end, and the Budget Control Act of 2011 goes into effect. A series of tax cuts from the Bush years will expire, as new taxes for the national healthcare law starts, all the at the same time as the drastic spending cuts proposed by the 2011 Debt Ceiling settlement.

The article basically paints in the Republican into a corner between a rock and a hard place - either raises taxes on a few, or trigger taxes on everyone, a direct conflict with their campaign promise to not raise taxes. At the same time, President Obama has something of a dominant strategy, in this iteration of the game. He can either raise taxes on a few and cut spending, as the Democrats want, or raises taxes on everyone and blame the Republicans for their intransigence.

What's at stake here, is the U.S. economy of the next few years and the potential to dive into yet another recession if both sides refuse to compromise. However, the game, and subsequent strategies assume both players are rational...far from certainty given how dangerously entrenched the sides were in resolving the ceiling.


Tyler said...

This was a very interesting application of game theory. While I agree that Republicans are in a lose-lose situation, I don't think the Democrats have it any easier. The senate has not passed a budget in over three years. The government has been running deficits in excess of one trillion dollars for the last several years. It is also damaging that the healthcare tax will hit middle-class families the hardest.

The best outcome for both parties is where tax revenues are increased through the elimination of certain deductions for wealthier taxpayers without a change to the current tax rates, and significant cuts to spending are enacted. This will allow both parties to save some face. Republicans can say they championed the tax issue and reduced spending, and Democrats can say that they averted disaster and unified the country.

Unfortunately, the options in the game appear to be to do what is best for the party, or to do what is best for the country. Since both sides believe that their party provides the best solution to the nations problems, they will be incapable of distinguishing between the two options and will most likely choose party every time. What will be interesting for this game is whether it will play out as a simultaneous game or a leader-follower game. Now all we need is a leader.

Dr. Tufte said...

Moh A: 82/100, I see more than three instances of poor sentence structure and agreement, but they are interrelated and can be corrected in different ways, so I settled on taking off for three of them. I allowed capitalization of "Fiscal Cliff".

Tyler: 44/50 for two misspellings.

It is common for pundits to assert that the fiscal cliff will lead to recession. As a macroeconomist I think this fear is overblown; recessions aren't that predictable.

And, if I can steer Moh A in a new direction, as economists what we try to do is not assume that agents are irrational (as he does in the last paragraph), but to see how their strategies and choices could be rational. I don't think "sticking to your guns" is irrational for either party; instead it's an indication of the scale of benefit/cost they see in their outcomes.

We can see this again in Tyler's comment that the Senate has been unable to pass a budget. Perhaps this is because the costs to them of not passing a budget are actually really low. How many of them lost their seats over this?

Michael said...

I really like the idea of looking at the fiscal cliff through the game theory lens. Like Moh A, I believe Obama has the dominant strategy. I also believe Obama is likely to leverage this position of strength to his political advantage. In my opinion, game theory is interesting, but extremely unlikely to help in anyway. I essentially believe that the US has to "take it's medicine" at some point, so we should just get it out of the way regardless of the short-term implications. Like Dr. Tufte, I also believe the fears of the fiscal cliff are overblown. Americans need to realize that balancing the budget has never been more important. The only way to accomplish this is to cut spending and raise taxes. Everyone needs to be affected so we all become vested in this transformation.

madhatter said...

The game of chicken is interesting theory, but how does it play out? I don't think that republicans would engage in a lose/lose match, even while the democrats continue telling the big lie that they are willing to deal.
I think that politicians always do what is personally politically expedient. In this light, the democrats must continue to fund fiscal needs of welfare recipients, working poor, and union labor. If they don't, they lose the next election.
The republicans will get a concession or two; a bone to prance around with and claim moral victory.
This is great drama that diverts attention. Both parties will claim victory while continuing the big lie, that what we have is not a contrivance.
There will be no substantive change. Not having a budget means the cookie jar is wide open. This can will get kicked down the road until we have a fiscal disaster or a dictator. The politicians are too self serving and lack the will to do anything else. Particularly in light of the latest election; this is arguably, what the majority of the people voted for; an open cookie jar they can all plunder.

Dr. Tufte said...

Michael: 47/50 for "anyway" instead of "any way".
madhatter: 47/50 for repeating the same capitalization error a few times.

I think Michael has missed the point of game theory. It isn't that its "unlikely to help". Instead, it's that we're in the game whether we want to be or not, and we'd better think about the possibilities. This relates to madhatter's first point that Republicans are unlikely to engage in a lose/lose game; their problem is that they're already in a lose/lose game, and they need to figure out how to avoid the big loss.

And I appreciate Michael's views, but I think he's misinterpreted mine. I think the "fiscal cliff" is an acute problem that won't have acute consequences, but rather chronic ones. So, nothing big right away, but heavy on the long, drawn out, pain. I'm also not a big believer in the "take its medicine" view. I do strongly push the position that this is all about spending, and the focus on taxes is a dodge.

I think madhatter's comment is a thing of beauty. I have two thoughts which I hope can improve on it: 1) I don't think "fiscal disaster or a dictator" are the only 2 possible outcomes, and 2) I think that not only did people vote to keep the cookie jar open, but to protect the extra cookies they've already taken.

Clayton Parry said...

I like the comments that have been posted so far. I think that in the long-run if we as Americans are ever going to start becoming fiscally responsible now is as good of a time as any. However, to make this work Americans must assume the previously stated position of the Republicans; lose/lose.
We can no longer have our proverbial cake and eat it too. If we are going to increase taxes then spending cuts should also take place. The amount of revenue gained through the tax increases that are set to take place would be like fighting a forest fire with a water gun. I like the comment made by Michael in that, “Everyone needs to be affected so we all become vested. . .” It is going to take both sides of the aisle, both political parties, and all of the American people to change what has happened and work toward a more stable economy and a balanced budget.

Dave Tufte said...

Clayton 50/50.

Fair enough.

But, let me redirect. Perhaps the game we should be concerned with is not between Republicans and Democrats, but is rather between politicians and voters.

And perhaps the strategies for politicians are 1) spend more than we have, or 2) don't; while the strategies for voters are 1) vote for who spends the most on us, or 2) don't.

In this case, it seems to me that the optimal choice for each is strategy 1, but that this is the worst outcome for the country. Thus, a prisoners' dilemma.

The whole point of the prisoners' dilemma is that rational behavior gets us to the worst outcome. So chew on this: is it possible that democracy gets us to the worst spot?