Avoiding the Fiscal Cliff? Gaming US Fiscal Reform
“There are equations in which certain relationships become progressively explosive”
This quote by Alan Greenspan, one of the foremost economic minds of our time, is a warning of the volatile nature of the ballooning federal deficit. Caught in a vicious downward spiral “in which increasing interest payments increase the deficit and debt, leading to another increase in interest payments, and so on”, Greenspan emphasized that budgetary reform would eventually have to materialize in some point in the future. It seems that point in time is quickly approaching, as many individuals and investors brace for what has commonly been referred to as the “fiscal cliff”. This refers to the simultaneous expiry of tax breaks with the introduction of tax increases and spending cuts at the end of 2012, the culmination of which could push the US back into recession.
This complex financial quandary that the US faces became considerably riskier due to the explicit threat from the ratings agency Moody’s, in which it would downgrade the US credit rating if Congress failed to make progress on medium-term fiscal goals.This potentially downgrade, the second in two years, would dismantle the belief that US treasury securities are risk-free assets. This would have a significant effect on global financial markets as the pricing of many financial instruments depend on the yield of a risk-free asset. So far, however, the threat isssued by Moody’s has not been effective and understandably so as no president wants to push the US into a deeper recession with the already bleak economic outlook.
We can apply game theory in this situation as the threat issued by Moody’s has the objective of forcing cooperation in an increasingly “non-cooperative” game. The credibility of the threat, however, is in question as participants in this game feel they have more to gain from their non-cooperating behavior. Setting up a payoff matrix for this affair, however, can become extremely complicated due to unknown effects of how investors will respond to either a downgrade or the US’s persistence to avoid the fiscal cliff. Due to the uncertainty of these variables, I have set up a theoretical payoff matrix that attempts to quantify the actions of both the US and Moody’s.
Although the payoff values are arbitrary, the decision of each party can be quantified by the inclusion of variables that will affect its outcome. These variables include the long-term fiscal health of the US government, investors sentiment regarding the outcome of a downgrade, and the inherent reputation of ratings agencies. In the first instance where US adheres to policies regarding the fiscal cliff and Moody’s still downgrades US credit quality, which would most likely not happen, the US suffers short-term intermediate stress due to the downgrade but ends up on a financially stable future path essentially negating both effects. Moody’s reputation, however, could take a hit due to the inconsistency of their actions. The second instance where the US adheres to the fiscal cliff and Moody’s doesn’t downgrade the US has the highest payoff for both parties as the US maintains a higher credit rating and is better off financially in the future. This is also better for Moody’s as their inaction could potentially help their standing in the public eye. The outcome of the third instance where Moody downgrades the US due to its noncompliance with the fiscal cliff, however, depends heavily on investor sentiment about the relative safety of US debt. Due to the eurozone crisis, investors have flooded the US debt in order to find a safe haven for their money, and if they believe that even after a downgrade US debt can still be considered to a risk-free place to store money then the short-term affects will be negated. The long-term effects of having an unstable financial future, however, cut into the payoff of the US as measures will eventually have to be taken to reduce the budget deficit. In the final instance, the US is better off because they maintain their high credit quality status, but Moody’s reputation takes a significant hit as it did not follow-up its threat with action.
In this game there exists no Nash equilibrium, and will most likely be decided by a mixed strategy depending on the values placed on different variables. In examining all the variables, however, I believe that Us politicians will dismantle the cliff and avoid the potential disastrous effects of second credit rating downgrade, but not to the extent that Moody’s is expecting. Such a bargain would go a long way towards reducing the risk of a prolonged US recession, but it will take comprise by both political parties to enact fiscal reform that satisfies Moody’s.
Article is http://www.project-syndicate.org/commentary/gaming-us-fiscal-reform-by-mohamed-a–el-erian