Source: Barron's
Author: Larry Hatheway (Larry Hatheway)

In the movie “Don't Look Up” (Don't Look Up), scientists, played by Jennifer Lawrence (Jennifer Lawrence) and Leonardo DiCaprio (Leonardo DiCaprio), tried to warn the US government to act before a giant comet collided with the Earth and destroyed all life on Earth. Unfortunately, “political dysfunction” (political dysfunction) led to a series of mistakes, threats, delays, and a chaotic agenda. In the end, the Earth was destroyed , because politicians, the media, and the market don't seem to think everything will actually get this bad.

The US debt ceiling is currently one of the most stressful issues in financial markets.House Republicans announced a “moratorium” on discussions last Friday, just as an agreement to raise the debt ceiling seemed close to being reached.

What will happen next depends on the motives of the actors. It is worth pointing out that there are more than two parties at the negotiation table this time; what will happen next also depends on what the two sides have backup plans in the event that the impasse cannot be broken and the US is likely to default.

In the following, we'll discuss the game theory aspect of debt ceiling negotiations, although it may not answer the main question that investors and ordinary people ask — will the US default? But it may be possible to reveal the motivations of key players and how those motivations influence the final outcome, including the impact on the market.

First, the current situation is not part of the classic prisoner plight, which is a good thing. The prisoner's plight means that prisoners tend to cooperate, but the motive for not cooperating can result in a “double loss.”

There are three possible outcomes.First, the two sides finally reached a solution through cooperation and negotiation; second, one party participated in the negotiations in good faith, but the other did not participate in the negotiations in good faith. Under such circumstances, debt ceiling negotiations would not be similar to a prisoner's plight, because the negative rewards (losses) of non-cooperation could be so great for both parties that cooperation became the most likely outcome.

This alone explains why financial markets have remained strong so far, even though the default deadline is getting closer (US Treasury Secretary Yellen said the deadline is June 1). The losses implied by not being able to reach an agreement are seen as being politically, financially, and economically disastrous, so the collective wisdom of the market is that an agreement will be reached before a default occurs.

What is the cost of the game? On the political front, following the marginal policy strategies of the 1990s and early 2010s, House Republicans [first under Speaker Newt Gingrich (Newt Gingrich) and later under Speaker John Boehner (John Boehner)] experienced setbacks in public opinion polls because voters mostly blamed them for disruptive government shutdowns and market fluctuations. The Republican Party currently holds the majority of seats in the House of Representatives by a narrow margin. Speaker McCarthy must be nervously examining this period of history when thinking about his political future. Similarly, the 16 House Republicans representing the districts President Biden won in 2020 must do the same. If the debt-ceiling debacle causes voters to blame the Republicans, voters in those districts may easily switch to the Democratic Party.

The economic and financial costs are difficult to determine. The credit risk premium on US Treasury bonds is likely to rise, and it is likely that it will only slowly decline, thereby increasing the cost of debt repayment borne by taxpayers; financial markets may suffer a devastating setback, increasing uncertainty about the overall economy, and is likely to trigger a recession.

For all of these reasons -- the political, financial, and economic costs of default --McCarthy may not ultimately represent a united front within the Republican Party in negotiations with the Biden administration. The hardline Republicans in the House of Representatives are far less likely to compromise than the moderate Republicans representing marginal seats.

So is it possible for House Republicans to split and let all House Democrats and a few moderate Republicans form a majority and pass a bill to raise the debt ceiling? There doesn't seem to be such a rift in the Republican camp at the time of writing, but it's worth noting that in 2013, the risk of defection was an important driver for compromise legislation that finally ended the debt ceiling crisis.

The nature of the negotiations also depends on the parties' backup plans. If McCarthy thinks his best chance in politics hinges on getting major concessions to cut spending from the Biden administration, then he's fully motivated to woo them with the kind of hopeful language he used last week. But if McCarthy ends negotiations, what are his backup plans? In a situation where he doesn't want to be defeated by nihilism (“To save America, we have to bankrupt America”), does he really have a reliable backup plan if the party he represents isn't willing to compromise?

McCarthy's backup plan may allow for a “free vote” to raise the debt ceiling. Doing so would be tantamount to allowing moderate Republicans to change their positions and ensure that the bill passes.This may not be a good outcome for McCarthy, and could lead him to directly confront the Republican hardliners, but it appears to be one of the few choices he has left.

On the other hand, the Biden administration has a more attractive backup plan. Although it may not be perfect or the first choice, no matter what, Biden seems to have more cards in his hands than McCarthy.

First, the Treasury could appeal to the 14th Amendment to the US Constitution (which states: “The validity of public debt authorized by law... cannot be questioned”) to repay the debt through loans, leaving the question of whether the Constitution is on its side to a protracted court battle. This strategy could at least buy some time.

Another strategy is for the Ministry of Finance to issue premium bonds (bonds sold at a price higher than the face value). These bonds are not included in the debt ceiling.

Finally, according to the Constitution, the Treasury can mint platinum coins of any face value and sell them to the Federal Reserve to raise enough money to pay off debts.

Although Treasury Secretary Yellen has said that these measures are not being considered, when faced with default, market chaos, a heavy blow to the economy, and voter boycotts, people can't help but wonder: Will the government sacrifice its principles for expediency?

In a serious game, contenders need to have a rock-solid position, and there must be no obvious rift.A sound strategy also requires a backup plan — what to do when all else fails. Having some flexible options is also really helpful — no matter how annoying they are — that can be used to avoid worse results.

In the serious game of debt ceiling negotiations, the Biden administration seemed to have the upper hand. This is probably not a good thing, because it may make the government stubborn, which in turn will lead to an outcome the government doesn't want to see — default.

However, the situation facing House Republicans and Speaker is also very serious. Some people think that surrendering to nihilism has always been an option, but this will only happen if the political parties remain united, and there is currently no unity within the Republican Party.

Finally, are investors being overly complacent in the face of these risks? Perhaps, before the US government completely defaults, other poor outcomes (such as the US sovereign rating being downgraded again) could hit the market hard.

However, if the market's collective bet is based on the possibility that the government will default, then the guarantee for relatively calm market pricing seems to be the comparative advantage and weakness of the negotiating parties.

I hope we can all “raise our heads” in the end.

Editor/jayden