By: Liz Strait, PhD
Introduction
The latest news has brought attention to the potential consequences of a failure to reach bipartisan agreement on raising the debt ceiling—using terms such as “economic chaos,” “market panic,” and “painful crash” in attention-grabbing headlines. This scenario resembles a high-stakes game of chicken, where neither party wants to yield, leading to a lose-lose outcome if resolution is not reached. This political standoff serves to increase uncertainty for Americans, who are already grappling with economic insecurity caused by various factors such as inflation, the remaining ramifications of COVID-19, and rising interest rates. Given these challenges, it is crucial Financial Professionals (FPs) understand the emotional and cognitive responses of investors to predict how they may react to the current situation and help them make informed financial decisions.
Background
Recent news has been focused on the potentially disastrous outcomes should there be no bipartisan agreement on raising the debt ceiling. Both sides are negotiating based on other desires related to their political party’s goals (reduced spending and budget cuts vs. maintaining the status quo). This situation is basically a game of chicken, where the outcome is lose-lose if neither party yields.
In game theory, this is called an “anti-coordination” game—each party wants the other to yield while they stay-the-course. Should one party concede while the other doesn’t, the relenting party receives a detrimental blow to their pride and reputation (the latter of which is important in politics due to reelection and ongoing negotiations). In the interim, the biggest loser is the American public. Individuals have been overwhelmed with unprecedented uncertainty and market volatility due to inflation, COVID-19, mass tech layoffs, increasing interest rates, and prognostications of an impending recession.
With this latest political strife, it’s possible many investors who were able to remain calm and steadfast previously, will be pushed over the edge into emotional reactivity regarding their financial plans. Before discussing the emotional biases and responses FPs may see, what causes them, and what to do with them, there are some important details about the game of chicken that should be addressed.
First, each player wants the other to relent, and to get them to do so, they must make a credible threat. Second, there is always the introduction of uncontrollable risk—something could happen along the way that results in catastrophe regardless.
Now, let’s contextualize this in the game currently being played over the debt ceiling.
1. Is each party making a credible threat to the other?
For the House/House Leader: no. Biden isn’t making any additional demands beyond raising the debt ceiling, so this looks much more like the GOP being opportunistic than the counter of staying the course while raising the debt limit.
For the President: yes. There is the possibility the Administration could invoke the 14th Amendment. This effectively forces Congress to yield and change the proposed bill ensuring the Administration wins either way. In terms of reputational outcomes, while the GOP may gain leverage in future negotiations with House and Senate Democrats by refusing to relent, the cost of doing so (saying they are willing to let the U.S. default if they don’t get what they want) is far greater reputationally.
The reality may involve some concessions on either side, and not complete defeat, but ultimately, neither party wants the US to default.
2. Is there uncontrollable risk?
Yes. There always is. But the likelihood of economic and financial pandemonium is highly improbable. So, why even bring it up? Individuals overreact to small probabilities and underreact to large probabilities due to subjective probability distortions (e.g., research has found that people treat a 1% probability more like 6% and a 99% probability more like 91%). This is why emphasizing the small probability of catastrophe, or the large probability of no catastrophe, may not be as effective as you were expecting.