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Fiscal Cliffs: Lurching towards more precipices?

Compromise on revenues and expenses.

Focus on enhancing tax revenues.

Focus on reducing expenses

No compromise: taxes go up and expenses are cut.

Figure 1. Strategies and preferences of fiscal conservatives and liberals.

A vote past the deadline but before everyone sobered from the New Year celebrations saved the United States economy from a plunge into economic chaos. Reports have emerged how distrust among those involved in negotiations, disagreements within each party, shouting matches and miscalculations took the nation to the brink.1 Even as the votes in the House of Representatives were being counted, we were warned that the nation is rushing towards other cliffs that it will reach within two months. Given that a member from the minority community was elected for the first time as the President and that he was successful in getting social legislations like health care passed, it is not surprising that the political tension is so high. Even so they are mild compared to what is occurring in some legislatures around the world and the United States has a record of raucous political debates at times of social change. The difference between then and now is that the United States has the largest economy in the world, trade in goods and services intertwine the economies of a larger number of nations than ever before and the communication technology flashed information fast enough to affect decisions around the globe in real time. There is no disagreement about the unsustainability of the current level of budget deficit and the Congress, having rejected the grand bargain, has now to find a solution to containing the government expenditures. More pressing is the need to ensure the solvency of the U.S. government by allowing it to borrow till the gap between revenue and expenses is closed. Since increasing revenues and reducing expenses affect various segment of the population the rich and the poor, the urban and rural, those in industry and in agriculture differently, each group is passionate in defending its interests. This is no substantive evidence that a modest tax increase will stifle the U.S. economy.2 The debate is fueled mostly by disagreement over the role of government and by each group jockeying to pass the burden to others.

While each group tries to push the negotiation in its favored direction, game theory the branch of economics that analyses strategic interaction warns that there is the danger that the outcome can be one not favored by either.3 This is demonstrated, using a binary choice between higher revenue and lower tax in Figure 1 above. The conservatives always prefer reducing the size of government to achieve budget balance. They prefer Strategy 2 to Strategy 1 as represented by the downward pointing red arrow. The liberals always prefer solving the budget imbalance by increasing tax revenue and using it to for funding social policies. They prefer Strategy B to Strategy A as shown by the blue arrow. If both political groups insist in pursuing their policies, their choices end the economy in the lower right hand cell. The reduction of government revenue and increase in taxes will lead to a serious economic crisis and this is the outcome that the legislators have to consider when making a choice between two cells in the opposite corners of the table. On Tuesday night, members on both sides of aisle had a more complex choice before them as their constituents have many interests but the dilemma laid out in Figure 1 is valid in higher dimensions as well. In an earlier article, I argued that, faced with that consequence, both groups will pull back from pushing the economy to a recession and that the threat of about fiscal cliff so blown up by news media is shadow boxing.4 On December 31st, I feared that I have made a fool of myself but fortunately for the U.S. economy, a political compromise worked out in Senate was accepted by the House of Representatives. Ending up in the least desired outcome is not only logically possible but such outcomes have occurred in the past. Management and workers disagree and frequent strikes and slowdown lead to the bankruptcy of the firm that hurts both management and workers. Nations threaten each other with war over dispute over territories (as is occurring between China and Japan) or groups within a nation threaten civil war over religious issues as happening in the Middle East. A breakdown of negotiations over health care cost or extending debt limit is possible but I still believe that the cost of disrupting a vibrant economy with a well-established political system is too high and predic that, in the end, a compromise will be worked out.
1.

http://www.politico.com/story/2013/01/the-fiscal-cliff-deal-that-almost-wasnt-85663.html?hp=f2; http://online.wsj.com/article/SB10001424127887324731304578193770576333616.html.==
2.

The recent recession is the main source of economic distress for firms. It overwhelmed the Bush tax cut and, going the other way, one wish there was a study that showed the tax increase needed to reduce the profit level of firms to the level in last few years, if demand had remained at the pre-recession level. Statistical difficulties in such a conjectural comparison seem to have discouraged undertaking such an analysis.
3.

http://www.socribd.com/doc/49513234/Opportunities-and-Choices, pp.134-36. Prisoners dilemma is the name given to this class of strategic problems.
4.

http://www.scribd.com/doc/115340400/Who-is-Afraid-of-Fiscal-Cliff

Rama V. Ramachandran
http://www.visualeconomicanalysis.info/index.html Facebook: Ramanomics
Copyright 2012 Rama V. Ramachandran

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