The Usual Game of Chicken

By Co-Founder & CIO, Dr. Charles Lieberman

The debt ceiling debate is heating up and many investors are nervous, which is precisely what  both parties are trying to accomplish.  Both sides are trying to get their own preferred outcome, although neither has a working majority to push through its programs.  So, some sort of compromise is necessary.  But in any such negotiation, being hard-nosed and willing bring down the entire system raises the stakes in both directions.  It may force the other side to concede.  But it risks making you look irresponsible.  The easiest way to describe the dilemma is the classic game of chicken, with each side hurtling towards destruction, but retaining the ability to compromise to avoid a catastrophe.  And economic theory tells us that such negotiations almost always result in a last minute agreement.  And to make this worse, the last minute can always be deferred by agreement of the parties, so at least in theory, there is no real last minute.

The approach of the Biden Administration with regard to the debt ceiling is actually textbook.  It is pointing out that a default would be very harmful, even devastating, and trying to make the case that the Republicans are so irresponsible that they could cause a default.  Every prior incumbent Administration, both Democrat and Republican, has taken the same approach.  As the party out of power, the Republican approach is that the Administration is fiscally irresponsible and the Republicans have put a debt ceiling bill on the table via a vote in Congress, which passed their bill, yet the Democrats refuse to even negotiate at all.

Had the Republicans failed to pass a budget bill, the onus of a default would likely have been placed at their feet, which might well have forced them to cave.  But having passed that debt ceiling bill in Congress, while Democrats refused to negotiate, they shifted the onus for failure to the Administration.  That’s why a negotiation has started.  The Administration couldn’t refuse to negotiate once that bill passed Congress without risking being blamed if a default occurred.  So, the two parties are now talking about a compromise.

Neither party has an incentive to reach a quick solution.  An early agreement implies that one side, but likely both sides, left something on the table.  It is always better to delay any agreement, since the other side might make one more concession.  That’s why almost all such negotiations get dragged out and resolved only at the last moment.  This is truly classical negotiating behavior.  It is textbook.

But the truth of the matter is there is no real last moment.  A default can always be averted by both sides agreeing to a temporary debt ceiling hike for another week or month.  Such a deferral is always a clearly preferred outcome to a default.  Knowing that they can always defer a default reinforces the likelihood that a deal will not occur well before the last possible moment.

The only factor that ultimately forces a deal to be reached is that neither side wants to be seen by the public as obstructionist and responsible for the fallout of a default.  That would be very costly politically.  Even a deferral gives the public the impression that each side is fighting for its beliefs and programs.  That’s acceptable.  Coming across as stubborn, uncompromising, and allowing a default to occur is not politically acceptable.  That’s why a compromise has always been reached before any default actually occurs.  And that remains the most likely outcome.  There will be hard negotiating, plenty of threats from both sides, but a compromise remains most likely at the very last moment, or even after the last moment by deferring the last moment, to avoid an actual default.  It is why most investment professionals and political insiders expect an agreement without a default.

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