Friday, July 22, 2011

Trigger Madness: A Clue to How Dumb the Debt Ceiling Deal Truly Is

Garry Kasparov not withstanding, life is not much like chess, but sometimes the wisdom of one does rub off on the other. One thing I learned in my playing days is that you are at your greatest risk of doing something dumb when you think you are being clever. A current case in point is the crucial role played by “triggers” in the emerging debt ceiling deal.

First, let’s look at it from the point of view of Obama. He thinks the problem is that credit markets may shift their sentiment regarding the long-range US fiscal position. Long rates on Treasuries are low right now, but how can we be sure they will stay that way? Wouldn’t it be better if we could lock in a decade-length deal that would stabilize public debt as a percentage of GDP?

But the problem is that we live in a democracy. Every two years there is an election, and the new politicos in charge may want to reverse the policies of their predecessors. How can we lock in any policy for the long run? This is the time consistency problem.

Ah, but there is an oh-so-clever solution: impose on yourself and your negotiating partner a horrible outcome that will come to pass unless you follow through with your commitments. This self-threat is the “trigger”.

Like many economists, I first heard about this strategy from Thomas Schelling. He describes a situation in which you are being held by a kidnapper. You want to be released, but the kidnapper is rationally afraid that you will reveal his identity. Of course, you could promise to never do such a thing, but how can the kidnapper know that you will keep this promise? Once you are released, it will be in your interest to go to the police: your incentives then will be different from what they are today. Schelling’s very clever solution is for you to share with the kidnapper some awful fact about your life that you want to keep secret. What this does is to keep your post-release incentives the same as your pre-release. The ability of the kidnapper to spill your secret is the trigger that keeps you honest. (I have always wondered how common it is for people to have a secret that is awful enough to do the job, but that’s another story.)

In effect, Obama and Boehner are offering to share secrets, to each bind their future selves to a long-term deal so that something horrible, like repeal of the Bush tax cuts (horrible to Boehner) or the removal of the health insurance mandate (horrible to Obama) doesn’t happen “automatically”. One convenient feature of this strategy is that the timing of the various aspects of the budget deal don’t matter. If the cuts come first, but the revenue increases don’t happen until several years from now, it’s not a problem because the triggers ensure that all aspects of the deal will eventually materialize.

Except that it’s all an illusion. The triggers being negotiated by Obama and Boehner are legislative, not constitutional. They can be undone by a future Congress or president. If Michele Bachmann is our new president come 2013 (gulp), I’m sure she will be happy to remove the tax increase trigger, especially if she has a Republican congress to work with.

The general point is that the hold-yourself-hostage trigger strategy does not solve the time inconsistency problem in a democracy, because part of the meaning of democracy is that new governing majorities have the power to undo the acts of those they replace. It is not possible for Obama to negotiate a ten (or more) year plan with the Republicans—period. He can push for actions to be taken during his term, and after that it’s up to the next president.

Of course, the markets know this well. Suppose there is a change in investor sentiment, and, against all logic, potential creditors decide that the US government is at risk of being unable to service its debts. Do you suppose they would be placated by promises to cut deficits several years down the road? Look at Greece and Italy. When interest rates shoot up, the only bone governments can throw is immediate austerity. Bondholders are perfectly aware of the time consistency problem, and promises mean nothing to them.

But that’s why the whole debt ceiling charade is so dumb. Bondholders are happy to hold Treasuries, even with long maturities. We don’t need austerity any time soon. And if the tide ever changes, distant promises will be irrelevant; the only thing that will matter will be fiscal policies at the moment of crisis.

The only thing we can do, although it is apparently too much for us, is to act intelligently in the present. Getting current fiscal policy right would be a good place to start, and addressing longer-term challenges through investments in people and infrastructure, along with cost controls in health care, would be a good way to continue.


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