Is the United States about to leap off its "fiscal cliff" and drag the rest of us into the economic abyss? Game theory tells us that this is not likely.
President Barack Obama and the Republican-dominated US Congress created this precipice by passing a law last year to force both sides to agree on a fiscal plan by the end of 2012.
Failure to agree will trigger automatic tax increases and spending cuts in 2013 that are likely to cause a 3 per cent fall in gross domestic product and a loss of 3.4 million jobs in the United States by the end of next year.
A deeper US recession will in turn lead to a sell-off in stock markets and a global recession. That is why analysts of all stripes are trying to predict whether Obama or the Republicans will jump off the cliff or pull back.
Game theory, a mathematical discipline used to analyse conflict, is one tool being used to predict the outcome.
The goal is to seek a solution known as the Nash equilibrium so that each player in the game cannot improve his outcome by taking any other action.
As the each side pushes for its fiscal plan in the face of disaster, they are essentially playing a game of chicken. In this game, the Democratic White House and the Republican Party is each daring the other to accept its fiscal proposals, knowing that if neither side concedes, the US economy will crash down the fiscal cliff.
The game of chicken, which has been extensively researched by game theorists, can convey a sense of the dynamics among the players in the high-stakes game going on in Washington.
In the chicken game, the winner is the player who drives straight while the other swerves, the loser is the "chicken" who swerves but avoids a crash, and a crash is the worst outcome for both players. This produces a situation where each player, in trying to secure his best outcome, risks the worst - driving straight at the other to force him into swerving. The diagram here is a game-theory representation of the choices.
When both players drive towards each other (the lower-right quadrant), one of them will swerve to survive, moving to either the upper-right quadrant or the lower-left quadrant. One driver will emerge the winner. When both drivers swerve (the upper-left quadrant) the one with the nerve to win will decide to drive straight. That will also result in a move to either the upper-right quadrant or the lower-left quadrant with one driver emerging the winner.
Hence, in this chicken game, the only two equilibrium conditions are when one driver swerves and the other keeps driving straight (upper right and lower left). In this condition, known as the Nash equilibrium, neither driver will change his position because that will worsen his outcome.
There will be no crash although we cannot tell which driver will be the winner.
To draw the parallel between the chicken game and the fiscal-cliff game in Washington, replace Driver B with Obama and Driver A with the Republicans. Driving straight would represent the fiscal plan stubbornly promoted by each player. Swerving would represent conceding to the other side. If neither side concedes, a crash will be equivalent to plunging off the fiscal cliff. If neither side acts, it's a tie in the chicken game, but in the political game the US economy will still drop off the fiscal cliff. The law will expire at the end of 2012, no new fiscal plan will be enacted, the tax rises and spending cuts will go into force, the US economy will contract, and so on.
As in the chicken game, Obama and the Republicans, led by House Speaker John Boehner, are signalling that they will stay the collision course, while hoping the other side will concede. They are competing to occupy one of the two corners in the diagram: the upper right for the Republicans, the lower left for Obama.
The theory predicts there will be a winner whose fiscal plan will prevail and the loser will eat humble pie. The important point, according to game theory, is that the falling off the fiscal cliff can be avoided.
While there are structural similarities between the chicken game as described by game theory and the political struggle between Obama and the Republicans at the fiscal cliff, there are also big differences. The key problem with game-theory analysis of any conflict is that human behaviour and emotions cannot be computed through mathematical variables.
The players in the chicken game are theoretically driven by survival and pride, whereas the factors motivating Obama and the Republicans are far more complex. In the chicken game, the payoffs are the same for both drivers: win, lose, tie or crash. In the political game, Obama's payoff far outstrips the passage of his fiscal plan, but impacts the prestige of his presidency in his last term. The Republicans, meanwhile, have to contemplate the consequences of losing yet another battle to Obama after his re-election in November.
The hope is that while the two sides engage in chicken game-type manoeuvres, they recognise the enormous stakes involved and reach a compromise that preserves the confidence of the financial markets on the long road to sustainable economic recovery.
Tom Yam is a Hong Kong-based management consultant with a doctorate in electrical engineering and an MBA from the Wharton School, University of Pennsylvania. He has worked at AT&T, Ernst & Young and IBM