Stabilization Games Revisited

OK, since my body clock still thinks I’m in Australia, I (TP) think it’s OK to violate our no-posting-in-the-US rule for just this once, to follow up on my earlier post on the debt ceiling.

The question here is, how did my little model do? The answer is, good not great. There are a couple of issues here. The outcome–a near complete capitulation by the Ds to the Rs–is not my final prediction, so that’s not good. But there are several reasons why a little model might not predict reality.

  • The model is wrong somehow. I don’t think is it. For what I intended the model to do, I think it stands up very well in explaining the essential logic of the debt ceiling crisis. The logic of the positions is correct, from what I can tell. It’s just that the Rs stood firmer than I anticipated, a prediction which only comes out informally at the very end of my discussion.
  • The model makes technical simplifications. This is part of it: due to the fact that I’m not any good at math I only entertained a 2×2 game structure with discrete strategies (vote yes or no), and clearly any actual debt ceiling negotiations involved negotiations allowing for continuous strategies. The model sacrifices reality to be more tractable, with obvious consequences.
  • Actual events are random draws from a distribution of possible outcomes. Maybe relevant too. This is what ever good poker player knows, and most critics of formal theories of politics forget. Think about it this way: if you’re playing no limit Hold ‘Em and find yourself raising pre-flop with pocket aces, but get beat by someone who flops a boat, you probably didn’t make a mistake by raising pre-flop, you just got a bad beat.
  • People aren’t rational. Possible. I think in the case of Obama himself, there’s evidence that he is not responding to incentives and new information about his opponents in a way that a rational Bayesian learner would. He seems to believe things about the Rs’ willingness to compromise that don’t seem compatible with reality. [ed.–Would love MGr’s and MGl’s reactions to this claim.] Beyond that, everyone else seems pretty rational to me.
  • Games are nested. I think that this the real issue. We can’t forget that the final debt ceiling crisis is part of a much larger game between the Ds and the Rs, and a lot of the relevant considerations for players calculating optimal strategies are external to the specific vote on whether or not to raise the debt ceiling and the small number of parameters I’ve included. I’ve long thought that the very fact that we had a debt ceiling crisis at all means that the Ds had already lost the ability to make and defend coherent economic policy positions. I just thought that they would stand firm.

The good news, as I mentioned before, is that in capturing the essence of the interactions between Ds and Rs over the debt ceiling, and understanding why the crisis looked the way that it did and lasted as long as it did, my exposition does well.

The real news now though is the market reaction (not great) and the subsequent economic data which has been released (very discouraging). What is striking to me now is a point to which I alluded earlier: the complete and utter refusal of US politicians to advocate for a coherent policy response based on basic economy theory. We used to know that when interest rates were really low but banks still weren’t lending and the economy was still stalled, governments should spend. Today, no politician–not a D, not an R, not a president–is willing to take this position. Instead, Washington is obsessed with debt and tax cuts. The reason why no politician will explain to you precisely why cutting taxes and decreasing spending over the next 20 years will help the US economy over the next 5 is because, well, it won’t.

There are various reasons for our politicians’ current ignorance. One is the really terrible state of economic literacy among the Americans. Lots of people study business in college, fewer study macroeconomics. The really smart ones who do study macroeconomics work in the financial sector, not politics, and they are screaming for more government spending right now. One is that macroeconomics is difficult, and that leads people to try to look for analogies in how you run a national economy in how they run their household or their small business, which create a huge fallacy of composition (if your household is almost bankrupt you should stop borrowing, and that is not necessarily true if you’re a national economy). One is possibly naked greed, but I don’t think that that is it really, because a greedy person would be willing to trade a higher tax bracket for a much higher income (which a good economy will give you), and that doesn’t seem to describe the nature of the debate right now.

But there also might be something in the way that leaders lead. I think that this is important, and not something amenable to game theoretic analysis. I can pick on Obama, but it’s not just his fault, it’s a general problem among the Ds, the party that would have the ability to advocate a classic Keynesian response to the current crisis. They seems unwilling or unable to stand up and recite the lessons of Econ 101.

UPDATE: Another obstacle to embracing a coherent policy response to our current economic maladies might come from academic economics, in the form of real business cycle theory. For better or for worse, RBCT enjoyed great prestige in the 1980s especially, and its intellectual champions remain active and influential. Simplifying greatly, RBCT starts with the assumption that all markets for goods, labor, and capital clear, which means that the business cycle–that is, the variation around the trend in how economies perform over the long term–must be explained by random shocks (yes, literally) to the economy. You get terms like “adverse technology shocks” to explain why recessions occur (Noah Smith discusses the logical implications of this sort of view applied to the current crisis).  Sneakily, then, economists who follow this line of thinking don’t have to think carefully about the origins of recessions, because they are unanticipated and unpredictable, or else they wouldn’t be random. One additional consequence of this line of thinking is that government action (monetary policy or fiscal policy) can at best do nothing to redress the business cycle. Here is an early, devastating critique from Larry Summers.

What makes this relevant for my discussion is that this sort of thinking is currently popular among many of the libertarian types of economists who tend to have blogs and lots of readers. The internet and libertarians go together like PB and J. It’s unlikely that many of these people strictly believe that RBCT is a good model; rather, they like the implication that government action can never be useful, and they sort of latch onto RBCT from time to time because that’s one of the things that  RBCT says. Blog readers usually don’t know that ins and outs of the models that produce these predictions but my sense is that they are still influential among the commentariat.

Comments 6

  1. Josh August 5, 2011

    The Model Makes Technical Simplifications + Games Are Nested: The actual cuts enacted into law are infinitesimal; the bulk of the cuts to come take place after the next election cycle and are subject to revision.

    As for the Ds policy response as a whole, there was a time to advocate a classical Keynesian response with a large Congressional majority to an open-minded public, and it was spring of 2009. Instead of infrastructure spending that might have had an economic effect, we got mostly state bailouts and politically-convenient grants. I’m not sure I’d call the public’s response to watching that play out and not wanting to see a replay economic illiteracy, though there’s certainly plenty of that to go around.

  2. tp253 August 5, 2011

    I agree totally. It was a political mistake to not have a real stimulus in 2009. Go back and read Krugman around that time, he’s making that point.

    However, if you think back about that time, there was fierce opposition already to any sort of stimulus at all. Obama thought that a stimulus of the size that he got was the best he could do. I think he negotiated poorly, but the point stands. Surely you remember state governors refusing to go forward with projects that were both shovel-ready and fully-paid-for. So even though I agree with you 100% that that was a big political mistake (failure of leadership, bravery, whatever), that doesn’t explain why so many Americans simply refuse to countenance the possibility that any spending at all could be useful.

    Small point: in these circumstances, infrastructure spending is no more stimulative than crony contracts to good friends if your goal is to just jumpstart the economy and encourage more growth in the medium term. Despite its faults, the stimulus did work, and as it winds down the effects of its absence are become clear. The government could fly around in helicopters and drop bundles of money randomly, and it would work. I certainly agree that for the longterm benefits of infrastructural spending are better than state bailouts and politically convenient grants, but that’s a separate issue. The position “I object to the way that the stimulus was allocated, therefore the stimulus did not work” is not a consistent one.

  3. Matt August 5, 2011

    Here’s the problem I have always seen with implementing Keynesian fiscal policy in a democracy: it’s hard (but not too hard) to get people to agree to deficit spending (either through tax cuts or increased gov’t spending, or both) when the economy is flagging.

    But it’s damn near impossible to do the opposite: raise taxes and cut spending while the economy is booming.

    So we end up with a unbalanced fiscal policy that continually adds government debt when the economy is sinking, but never reverses course in boom times. Instead, we try to control inflation through monetary policy.

    Now, I’m no economist. But this seems problematic.

    • tp253 August 6, 2011

      Matt, I agree that that is theory a problem, but not in reality.

      1. in reality, we know that it’s quite possible to have fiscal stimuli that expire. Obama did it in 2009. So at the very least we know that Keynesian fiscal policy does not automatically create continual increases in the government spending path.
      2. fiscal stimuli are a small portion of the long term debt. We don’t have the debt that we have because of accumulated fiscal stimuli, we have it because of poorly designed entitlement programs and a ridiculous military budget. Creating a “balanced fiscal policy” in terms of countercyclical spending would not at all solve our real problems. Another way to see this is to observe that Italy, Greece, Spain, Ireland aren’t in trouble because of unbalanced Keynesian fiscal management, they are in trouble because of deep, enduring problems in regulation and governance.
      3. I’m not sure that even if we have a fully unbalanced fiscal policy that the consequences for long-term debt/gdp are negative. That depends on how fast spending contributes to GDP relative to debt. The point of a stimulus is to shift the GDP path, so it’s possible that true stimuli are debt-neutral in a long term perspective even if we don’t cut spending in fat times (which I agree that we should do, but let’s just assume, following your worries, that we can’t). If that’s true then unbalanced fiscal policy need not add to long term government debt as a ratio of our ability to pay for it (GDP), which is what matters.
      4. Finally, assume that points 1, 2, and 3 are wrong. the normative implications of your argument come down to something like “I care X amount about the state of the economy now, but more about the state of the economy later.” That means you have to have a discount rate of greater than 1. That’s certainly a logical position to have, but inconsistent with every other piece of evidence of how humans operate, in the economy and otherwise. It’s just peculiar to me to assume that as a matter of public policy, everyone’s discount rate is greater than 1.

  4. Josh August 5, 2011

    TP: I am not sure about your characterization of what Krugman was calling for. Cf here: where he calls aid to states the most effective part of the stimulus. Additionally, he characterizes tax cuts as very ineffective, so he would apparently disagree with your helicopter cash proposal. Of course he certainly then, as now, called for a much bigger stimulus in any form.

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