Let’s Get Fiscal, Cliff!

With the 2012 election firmly in the rearview mirror, the discussion has turned to the impending fiscal cliff.  In a nutshell, the looming budget cuts (sequestrations) and tax increases are the result of the 2011 budget deal that increased the debt ceiling and staved off the need for further budget wrangling between the GOP and Democrats until, well, now.

Arguably, the 2011 budget deal represented a kind of agreeing-to-disagree (or, perhaps, “wait and see”) approach with respect to the hard choices facing aspiring budget balancers.  As I’ve written about before, the simple reality is that the earnest budget balancer must raise revenues in some fashion. This was perhaps okay with GOP glitterati, but definitively not if this revenue came about as the result of an arguably transparent increase in marginal tax rates.  (Rather, we should have a tax cut that was (more than) offset by limitations on deductions, which is not only a silly and cynical move to obfuscate, but doubly disingenuous, insofar as it misdirected attention from the absolutely unfair and economically unwarranted differential treatment of capital gains and interest income.)

So, anyway, with President Obama’s reelection, the bargaining game is a little clearer now.  Here’s where the “math” of this topic comes in (though there’s some math inherent in the preceding soapbox topping, too).  The fiscal cliff empowers Obama to the degree that he fears the triggers of the 2011 agreement less than do Boehner and his GOP colleagues (not to mention McConnell and his GOP colleagues).

In my corner of the spectrum, this is to my knowledge often referred to as either “Romer-Rosenthal bargaining” (due to Romer and Rosenthal (1978)) or, perhaps, crisis bargaining.  I often refer to this situation as the former, but to be fair and transparent, it’s really not.  The details are not that complicated, but the simplest explanation is that Obama doesn’t actually get to commit to a proposal.  Rather, he can make non-binding statements about what he would or would not veto, similar to Matthews (1989).

So what?  Well, theory indicates that there are two questions that are central to determining how this plays out (supposing that all of the players are rational and believe that each other is rational, and so forth—but if that doesn’t hold, then, well, you’re on your own, kid).  Making things (overly) simple and presuming that the Senate Democrats have the same preferences as President Obama, these two questions are:

1. What is the set of outcomes that both the GOP and Obama prefer to falling off the cliff?

2. What are the relative costs to the GOP and Obama of delaying an agreement between now and then?

An interesting and general characteristic of traditional, complete information bargaining models (which assume that, in this example, both Boehner and Obama know the answers to questions 1 and 2, above, and know that each other know the answers to these questions, and so on…) is that delay will not occur.  In other words, presuming (as seems realistic, given market reactions) that neither Obama nor Boehner prefers to wait to secure any given resolution to the crisis, there should be no delay in reaching this agreement.

To be practical about the matter, I don’t think they have refuted that prediction yet.

However, I also do not believe that Obama knows how much Boehner can stand delay in reaching agreement.  In particular, Obama seemingly has no interest in delay, as he has real matters to deal with, but Boehner has a much less transparent position.  Should he resolve this issue because of the uncertainty’s effects on financial markets?  Or would resolving it too quickly undermine his ability to corral his more boisterous copartisans?

This uncertainty, which I believe is definitively descriptive of Obama’s beliefs about Boehner (particular after the 2011 experience), might very well partially characterize Boehner’s beliefs about his own standing.  Regardless, it raises the important possibility of delay prior to ultimate agreement emerging as “option value” for Boehner.  That is, even if (or, actually, particularly if) Boehner is completely certain about, and assured in, his own standing with the GOP caucus, he has an incentive to vacillate, preen, and stonewall while dealing/negotiating with Obama regarding the final resolution to avert the fiscal cliff.

Note that this prediction comes about precisely in the absence of any assumed “ego rents” on the part of Boehner.  In a nutshell, the uncertainty about Boehner’s bargaining position relative to his own caucus can generate sufficient incentives for him to “act the diva,” and seem to hold court in a fashion befitting LeBron’s act leading up to “The Decision.”  The simple explanation of the strategic incentives underlying this is that Boehner can utilize Obama’s uncertainty about Boehner’s bargaining ability to make it appear like, even if Boehner does “care at least as much as Obama” about resolving the fiscal cliff in an expeditious fashion, that Boehner can’t “deliver a deal” equal to Obama’s “reservation price” (or, in other words, that Boehner can’t get his caucus to agree to Obama’s demands).  The implicit value to Boehner is that Obama, on the margin, will give in a little to secure what he perceives as the marginal certainty of securing a deal from Boehner’s copartisans.  In other words, at the end of the day, as 2011 purportedly demonstrated, Boehner may ironically (but completely classically from a game theoretic vantage point) benefit from being able to portray himself (accurately or not) as not being able to corral his own troops.  ”Sir, I told them gruel was sufficient to survive the night, but they simply insisted they’d die without gruyère.”

In such a setting, delay is essentially inevitable: given such uncertainty on the part of Obama about Boehner’s ability to deliver his own caucus (which is essentially the same as Obama being unsure about Boehner’s own “reservation price”), Boehner will/should at least “test the waters”–probably by losing/delaying some sort of test vote in the House.

Why does this matter? Well, once you recognize that Boehner has this incentive, then one recognizes that Obama has an incentive to overstate his willingness to “wait the GOP out.”  In other words, Obama’s uncertainty abut the GOP’s ultimate and effective preferences (more appropriately, the shared knowledge of Obama’s uncertainty) creates an incentive for Obama to create uncertainty about his own resolve.

Where does this end?  Well, my (and let me be clear it is at best a) guess is that the two sides agree to letting the Bush tax cuts expire for the top 2% of earners, limit deductions for something like the top 5% of earners, and take “halvesies” on some of the (discretionary & non-military) spending cuts.  I’ll leave it for another post, but these revenue tricks will probably net much less than one might expect if you apply the straightforward calculations based on the normal tax code, because a lot of the top 5%, not top 1% of households are already paying the alternative minimum tax (AMT) and accordingly having their deductions rather severely curtailed.  Thus, the “new revenue” from such a deal would be muted relative to expectations.

I am not sure that this is a bad outcome.  I feel like everybody (all 28 of us) who is paying attention to the details of this important part of the federal budget dynamic is implicitly hoping for a take-it-once-fix-it-all pill, and I also feel that all of us know that this might work ceteris paribus, but that nothing with respect to fixing a ~$1 trillion deficit within a year or two should be taken as ceteris paribus.

On that note, I leave you with this.