Monday, November 24, 2014

Gaming US Fiscal Reform

NEWPORT BEACH – It sounded like a really clever idea: Use a very public and sizeable threat to get bickering politicians to collaborate and compromise. Well, it has not worked so far, and the already-sizeable stakes just got bigger.

No, I am not talking here about Europe’s debt crisis, decisive resolution of which still requires greater cooperation and shared responsibility, both within individual eurozone member states and between creditor and debtor countries. I am referring to the complex fiscal situation in the United States – a fluid problem that has just been rendered more consequential by the recent warning from the ratings agency Moody’s that the US could lose its top credit rating next year if Congress fails to make progress on medium-term fiscal reforms.

Hobbled by the self-inflicted wounds of the debt-ceiling debacle in the summer of 2011 – which undermined economic growth and job creation, and further damaged Americans’ confidence in their political system – the US Congress and President Barack Obama’s administration recognized the need for a measured and rational approach to fiscal reform. To increase the likelihood of this, they agreed on immediate spending cuts and tax increases that would automatically kick in (the “fiscal cliff”) if agreement on a comprehensive set of fiscal reforms eluded them.

On paper, at least, this sizeable threat – involving blunt fiscal contraction amounting to some 4% of GDP – should have properly aligned incentives in Washington, DC. After all, no politician would wish to go down in history as being responsible for pushing the country back into recession at a time when unemployment is already too high, income and wealth inequalities are increasing, and a record number of Americans live in relative poverty.

Yet, so far, the threat has not worked. To understand why, we can appeal to game theory, which provides economists and others a powerful framework with which to explain the dynamics of both simple and complex interactions.

The objective of threatening a fiscal cliff was to force a “cooperative outcome” on an increasingly “non-cooperative game.” But, in the absence of a credible enforcer (and lacking sufficient mutual assurances), participants felt that they had more to gain from continuing their non-cooperative behavior.

Politicians on both sides of America’s political divide have generally felt that compromise would be viewed as a sign of weakness. Moreover, too many have made prior commitments – for example, promising never to increase taxes – that they find hard to break, especially ahead of elections that both sides deem to be of defining significance for the country’s future, reflected in the candidates’ campaigns, which are getting nastier by the day.

The cost-benefit calculations will likely evolve after the election in November. At that point, the cost of being singled out as collaborating with members of the other side – and thus the risk of being unseated by more extreme forces in one’s party – may well decline. Moreover, since early September, the potential benefits of cooperation now include avoiding an embarrassing credit-rating downgrade next year if medium-term fiscal reform does not materialize.

I suspect that some will be quick to dismiss the consequences of a Moody’s downgrade. And it certainly is tempting to do so. After all, the global financial crisis badly damaged the credibility of ratings agencies as a whole. Moreover, one would be hard pressed to identify any meaningful hit to the US from the decision by another major agency, Standard & Poor’s, to downgrade America’s sovereign rating in August 2011.

On the contrary, rather than spiking higher following S&P’s unprecedented move, US market interest rates continued to fall, reaching record-low levels. This seemingly contradictory fall in financing costs reflected an abundance of foreign capital seeking to invest in the US, including money fleeing from Europe. The absence of any adverse impact on government finances may thus lead some to dismiss the impact of a potential Moody’s downgrade in 2013.

Yet, those of us who are exposed on a daily basis to the inner workings of financial markets would caution against too upbeat an attitude toward a second downgrade by a major ratings agency. Moreover, the potential impact certainly is not linear.

Owing to the way that investment contracts are written and guidelines specified, there is a meaningful difference between a single and multiple rating downgrades. Were Moody’s to follow S&P in stripping the US of its triple-A rating, the most likely outcome is that the universe of global investors who are both able and willing to increase their holdings of US government securities would shrink over time.

Fortunately for the US, the immediate adverse impact on borrowing costs would be alleviated, if not nullified, by investors’ lack of readily available alternatives to US government bonds, as well as a Federal Reserve that has been buying large volumes of US Treasuries. But this is not a long-term risk worth taking.

Historically, it has taken countries many years of difficult fiscal-policy efforts to regain a triple-A status. And, while no one can be certain about where the limits lie, there are both theoretical and operational bounds to how many government bonds can (and should) be placed on the balance sheet of a modern, well-functioning central bank.

All of this suggests that, whether in the lame-duck congressional session following the elections or in the first few months of the new Congress, US politicians will likely dismantle the fiscal cliff. Based on an assessment of potential commonality among the political parties, such a compromise would limit the contractionary fiscal impact to some 1.5% of GDP.

Such a mini-bargain would go a long way toward reducing the risk of a serious US recession. But it would fall short of the type of fiscal reforms that would satisfy Moody’s. Such reforms require a grand bargain between America’s political parties, which in turn presupposes visionary leadership by both of them.

Read more from our "Fiscal Cliff Notes" Focal Point.

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    1. CommentedEnrique Woll Battistini

      The dissonance between academia, big business, and government in the U.S. is of such magnitude that the innovative grand bargain in Congress required to permanently avoid the fiscal cliff, as the People rightly expect, will never happen without a repeat of the Grand Depression of the 30s, because it would demand far-reaching changes in the current economic, social and political model tantamount to a new Social Contract, given the long-standing inequitable distribution of production, and gross imbalances in welfare, these being unstoppable changes which are not envisioned and much less discussed in the halls of power, and which must be, by their very nature, de facto. The model is obsolete; this is evident. The formal apparatus must yield and adapt, or it shall collapse.

    2. CommentedAlan Luchetti

      "Politicians on both sides of America’s political divide have generally felt that compromise would be viewed as a sign of weakness."

      But for that word "generally", this could be parsed to describe the reality of a handful of D hardliners up against a lockstep entirety of R hardliners. And, yes the Norquist pledge is instanced in the next sentence. Nevertheless, this paragraph reeks of politic false equivalence, a lack of which, no doubt, would be against PIMCO's interests.

      Obama has earned just criticism for pre-emptive compromise. Let not his spurned efforts at collaboration and compromise be in vain. Do not call for more of the same. Not after his re-election. How many times do the Rs have to say no before they are rightly dismissed as the cynical vandals that they indisputably are.

    3. Commenteddan hitt

      Well, in fact, it probably is a good idea to use insights from game theory to understand the dynamics of what is going on with the fiscal cliff, and who will cooperate with whom to do what.

      But surely the very biggest reason for our giant deficits is our hundreds of unnecessary foreign bases and multiple unnecessary trillion dollar wars.

      So i would ask Dr. El-Erian to explain using game theory or any other means why the awesomely large expenses are not even mentioned in talks of a "grand compromise", let alone put on the table?

      Perhaps the system really is "gamed", so to speak?

      In any event, the public would be nuts to allow its pensions to be stolen while the war elephant is still in the living room.

    4. CommentedPaul A. Myers

      All the Republican National Committee talking points are here:

      "Such reforms require a grand bargain between America’s political parties, which in turn presupposes visionary leadership by both of them."

      No grand bargain is required or needed. The US is having an election and after the election the Congress will start a slow lumbering process of deciding a variety of issues. That is the way the US Constitution has organized the place. Only elites interested in preserving the 15 percent capital gains tax rate talk about "grand bargains." Hey, it ain't American politics.

      "the debt-ceiling debacle in the summer of 2011- which undermined economic growth and job creation..."

      It did no such thing. The Republican House and Senate which refused to pass the Jobs Bill and other public infrastructure spending and a myriad of other jobs related bills undermined job creation. This was Mitch McConnell's strategy of undermining the economy so that Obama would be a one-term president. That is what undercut growth and jobs. It is a 100 percent Republican party responsibility. Why? The Republican party's sole and only goal in all of this is to preserve low tax cuts on capital gains and dividends. That's it. There's no other object on the Republican agenda. The rest of this is simple policy nonsense.

      Let's not "appeal to game theory." It is old-fashioned hardball American politics.

      The Republicans bet one way, and now it looks like they are going to lose. Tax rates will go up. Now we'll hear another stream of "sky is falling" from the financial elite.

      In January 2013, a lot of Republican congressmen and senators are going to look at the fall 2014 elections and decide they don't want to be on the wrong side of Social Security, Medicare, and Medicaid. That will concentrate their minds. So no grand compromise, but there will be a lot "go along to get along."

    5. CommentedProcyon Mukherjee

      If compromise is potentially a weak moral ground to be in, then ostensibly the American polity is gaming on a weakness for electoral rhetoric that leaves the vanquished to collect spoils from a moral debate meant for the public whose memory is shorter than the least count of recurring short cycles of recessions.

      With an output gap that is potentially in the 6% of GDP, and with rising penchant for eternal bond buying that would keep the zero lower bound permanent, we have the fiscal deficit looming into a certainty of credit downgrade while the expectation that the rest of the world is worse off could be a saddening reminder that the global savings glut which fueled so much of the spending spree may not last.

      Procyon Mukherjee

    6. CommentedJohnny (MoneyWonk)

      Moody's may say the U.S. is a bad bet, but the rest of the world still wants to give us money. We're like the least ugly contestant at the beauty pageant.