About the author: Larry Hatheway is a co-founder of Jackson Hole Economics, which originally published this commentary, and the former chief economist of UBS.
In the movie Don’t Look Up, scientists played by Jennifer Lawrence and Leonardo DiCaprio try to warn the U.S. government to take action before a giant comet collides with the Earth, destroying all life on the planet. Unfortunately, political dysfunction leads to false starts, threats, delays, and crossed agendas. In the ends, Earth is obliterated because politicians, the media, and the market don’t seem to think it could all really go so wrong.
The coming week promises to be a tense one for financial markets. On Friday, just when it seemed a deal to lift the U.S. debt ceiling might be in the offing, House Republicans declared a “pause” in the discussions.
What comes next? We honestly don’t know. It depends on the motivations of the actors. And, in this case, it is worth pointing out that there are more than two parties at the negotiating table. It also depends on the fallback positions of each side in the event the impasse cannot be broken and the U.S. risks default on its financial obligations.
In what follows, we consider the game-theoretic aspects of the debt ceiling negotiations. This approach is unlikely to answer the main question investors and ordinary citizens alike are asking—will the U.S. default?—but perhaps it can shed light on motivations of key participants and how those motivations could impact the final outcome, including for markets.
To begin, this is not a classical prisoner’s dilemma, where cooperation is preferred, but incentives not to cooperate yield a classic “lose-lose” (in other words, suboptimal) result. That is a good thing, as the (dis)incentives point to cooperation, not self-interested defeat.
If one thinks of the possible outcomes: First, each side cooperates to reach a negotiated settlement. Second, one side negotiates in good faith, but the other does not. Or third, neither side negotiates in good faith, then the debt-ceiling negotiations are not akin to a prisoner’s dilemma because the negative payoffs (the losses) associated with not cooperating are potentially so large for both sides as to make cooperation the most likely outcome.
That, alone, explains why financial markets have thus far held up despite the rapidly approaching deadline for default (as soon as June 1 according to Treasury Secretary Janet Yellen). The implied losses of not reaching a deal are thought to be so politically, financially, and economically disastrous that the collective wisdom of the markets is that a deal will be struck before a default occurs.
What are those costs? In political terms, following brinksmanship tactics of the 1990s and early 2010s, House Republicans (first under Speaker Newt Gingrich and subsequently under Speaker John Boehner) suffered setbacks at the polls as voters largely blamed them for disruptive government shutdowns and market volatility. With a razor-thin majority in the current House, Speaker McCarthy (who only took the gavel after 15 leadership votes within his own party) must be nervously looking at that history as he ponders his political future. So, too, must the 16 House Republicans who represent districts won by President Biden in 2020, which could easily flip to Democrats if a debt ceiling fiasco leads voters to blame the GOP.
As for the economic and financial costs, they are very difficult to ascertain. Credit risk premiums on U.S. Treasuries are highly probable and might only decay slowly, adding to the debt servicing costs borne by taxpayers. Financial markets could suffer devastating setbacks, raising uncertainty across the economy, quite possibly inducing a recession.
For all those reasons—the political, financial, and economic costs of default—McCarthy may ultimately not represent a unified front in the debt negotiations with the Biden administration. Hardline House Republicans, to whom he ultimately owes his position, are far less likely to compromise than moderate Republicans representing marginal seats.
Might it therefore be possible for the House Republicans to split, offering a majority comprised of all House Democrats and a handful of moderate Republicans to pass a “clean bill” increasing the debt ceiling? At the time of writing, there do not seem to be any such cracks in the Republican front, but it is worth noting that in 2013 the risk of defections was an important driver of the compromise legislation that ultimately ended that debt-ceiling crisis.
The nature of the negotiations also depends on the fallback positions of each party. If McCarthy feels his best chances politically depend on extracting major concessions on spending cuts from the Biden administration, then he has every incentive to lure them in with the type of hopeful language he deployed in the middle of last week. But if he pulls the plug on talks, what is his fallback position? Short of nihilistic idealism (“we had to bankrupt America to save America”), does he genuinely have a credible fallback if compromise for his side is impossible?
The answer might be allowing a “free vote” on lifting the debt ceiling, effectively permitting moderate Republicans to switch sides and ensure the bill’s passage. It might not be a great outcome for the speaker and it could place him in direct confrontation with the party’s hardline wing, but it appears one of his few options left.
From the Biden administration side, on the other hand, more attractive fallbacks exist. They may not be perfect or first resort, but it nevertheless feels like Biden holds more cards than McCarthy.
For one, the Treasury could appeal to the 14th Amendment to the U.S. Constitution (which reads, “validity of the public debt, authorized by law…shall not be questioned”) and simply borrow to meet its debt obligations, leaving the matter of whether the constitution is on its side to protracted court battles. At the very least, that tactic could buy time.
Another gambit would be for the Treasury to issue premium bonds (those sold above par value), which wouldn’t add to the debt ceiling.
Lastly, the U.S. Treasury, under the constitution, could mint a platinum coin of any denomination and sell it to the Federal Reserve, raising sufficient funds to meet its obligations.
And while Treasury Secretary Yellen has said that such moves are not under consideration, one must wonder when confronted by a possible default, market chaos, a severe blow to the economy and a potentially larger voter backlash, if the administration’s principles might be sacrificed to expediency.
When playing serious games, competitors need rock-solid positions, without obvious cracks in their armor. Sound strategy also requires a fallback position—what to do when all else fails. And it really helps to have flexibility—options that however distasteful can be utilized to avoid even worse outcomes.
In the serious game of debt-ceiling negotiations, it appears the Biden administration has the upper hand. That may not be a good thing, as it could make the administration obstinate, potentially yielding the outcome it abhors (default).
But from the perspective of House Republicans and their speaker, the deck also looks stacked. Nihilistic defeat is, one supposes, always an option, but it can only happen if party unity can be maintained, which is not a given.
Finally, are investors complacent to the risks? Perhaps. After all, other bad outcomes, such as a downgrade of U.S. debt and collateral disruptions, could lead to large market setbacks long before an outright US government default takes place.
But if the markets’ collective wager is based on government default probabilities, the relative calm of market pricing appears warranted by the relative strengths and weaknesses of the parties to the negotiations.
Let’s hope we can look up.
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