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It sounded like a really clever idea: Use a very public and sizeable threat to get bickeringpoliticians to collaborate and compromise. Well, it has not worked so far, andthe already-sizeable stakes just got bigger.
No, I am not talking here about Europe’sdebt crisis, decisive resolution of which still requires greater cooperationand shared responsibility, both within individual eurozone member states andbetween creditor and debtor countries. I am referring to the complex fiscal situation in the United States – a fluid problem that has just been rendered moreconsequential by the recent warning from theratings agency Moody’s that the UScould lose its top credit rating next year if Congress fails to make progresson medium-term fiscal reforms.
Hobbled by the self-inflicted wounds of the debt-ceiling debacle in the summer of 2011 – which underminedeconomic growth and job creation, and further damaged Americans’ confidence intheir political system – the US Congress and President Barack Obama’sadministration recognized the need for a measuredand rational approach to fiscal reform. To increase the likelihood of this,they agreed on immediate spending cuts and tax increases that wouldautomatically kick in (the “fiscal cliff”)if agreement on a comprehensive set of fiscal reforms eludedthem.
On paper, at least, this sizeable threat – involving blunt fiscal contractionamounting to some 4% of GDP – should have properly alignedincentives in Washington, DC. After all, no politician would wish togo down in history as being responsible for pushing the country back intorecession at a time when unemployment is already too high, income and wealthinequalities are increasing, and a record number of Americans live in relativepoverty.
Yet, so far, the threat has not worked.To understand why, we can appeal to game theory, which provides economists andothers a powerful framework with which to explain the dynamics of both simpleand complex interactions.
The objective of threatening a fiscal cliff was to force a “cooperativeoutcome” on an increasingly “non-cooperative game.” But, in the absence of acredible enforcer (and lacking sufficient mutual assurances), participants feltthat they had more to gain from continuing their non-cooperativebehavior.
Politicians on both sides of America’s political divide havegenerally felt that compromise would be viewed as a sign of weakness. Moreover,too many have made prior commitments – for example, promising never to increasetaxes – that they find hard to break, especially ahead of elections that bothsides deem to be of defining significance for the country’s future, reflectedin the candidates’ campaigns, which are getting nastierby the day.
The cost-benefit calculations will likely evolve after the election inNovember. At that point, the cost of being singled out as collaborating withmembers of the other side – and thus the risk of being unseatedby more extreme forces in one’s party – may well decline. Moreover, since earlySeptember, the potential benefits of cooperation now include avoiding anembarrassing credit-rating downgrade next year if medium-term fiscal reformdoes not materialize.
I suspect that some will be quick to dismiss the consequences of a Moody’sdowngrade. And it certainly is tempting to do so. After all, the globalfinancial 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 inAugust 2011.
On the contrary, rather than spikinghigher following S&P’s unprecedented move, US market interest ratescontinued to fall, reaching record-low levels. This seemingly contradictoryfall in financing costs reflected an abundance of foreign capital seeking toinvest in the US, includingmoney fleeing from Europe. The absence of any adverse impact on government finances may thuslead 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 offinancial markets would caution against too upbeatan attitude toward a second downgrade by a major ratings agency. Moreover, thepotential impact certainly is not linear.
Owing to the way that investment contracts are written and guidelinesspecified, there is a meaningful difference between a single and multiplerating downgrades. Were Moody’s to follow S&P in strippingthe US of its triple-A rating, the mostlikely outcome is that the universe of global investors who are both able andwilling to increase their holdings of US government securities would shrinkover time.
Fortunately for the US, the immediate adverse impact on borrowing costswould be alleviated, if not nullified, byinvestors’ lack of readily available alternatives to US government bonds, aswell 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-policyefforts to regain a triple-A status. And, while no one can be certain aboutwhere the limits lie, there are both theoretical and operational bounds to how many government bonds can (andshould) be placed on the balance sheet of a modern, well-functioning centralbank.
All of this suggests that, whether in the lame-duckcongressional session following the elections or in the first few months of thenew Congress, US politicians will likely dismantle the fiscal cliff. Based on an assessmentof potential commonality among the politicalparties, such a compromise would limit the contractionary fiscal impact to some1.5% of GDP.
Such a mini-bargain would go a long way toward reducing the risk of aserious USrecession. But it would fall short of thetype of fiscal reforms that would satisfy Moody’s. Such reforms require a grandbargain between America’spolitical parties, which in turn presupposesvisionary leadership by both of them.
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