Revenue Write-Down: Deal or No Deal

The shifting of the Federal Labor Government position from conservative fiscal stewards to that of aggressive deficit hawks bears striking resemblance to the behaviour of contestants on the popular game show, Deal or No Deal.

The way in which the Rudd Government has framed its first and second budgets is characterised by what decision theorists would regard as an inconsistent set of risk preferences. Prospect theory, as developed by Daniel Kahneman (Nobel Prize in Economics, 2002) and Amos Tversky provides a good explanation of the way it has behaved. In short, when faced with gains, a decision-maker (i.e. the government) tends to be risk-averse; when confronted with losses, she becomes much more risk-seeking.

The theory is responsible for adjusting the standard expected utility model of decision-making under risk. As it turns out context determines whether standard models work and when they don’t, as explained by scholars Rose McDermott, James Fowler and Oleg Smirnov:

It may be that standard models work well when environmental conditions are characterized by abundance. However, when the external situation changes and individuals or groups begin to face real or perceived threats to survival, preferences will change in the predictable way.

This type of predictable behaviour has been seen in Deal or No Deal contestants when they start to lose the possibility of winning the larger cash prizes (see here for an explanation of how the game is played). Instead of taking deals equal to the average of possible cash prizes remaining, they often play on hoping to score the remaining higher amount.

Let’s play

In the first round of his fiscal budget cycle, Treasurer Wayne Swan was dealt a winning hand: a fiscal position in surplus, a smoothly running economy, strong property and commodity markets, healthy business and consumer confidence, trade surpluses as far as the eye could see (this was Treasury’s flawed assumption) and historically low unemployment. In fact, the only dark cloud on the horison was inflation, which was driven in large part by high oil prices.

So, in keeping with Labor’s election promise of delivering sound economic management, he brought down a budget that was conservative: no major spending (which would put upward pressure on inflation), a continuation of the tax cuts that the previous government had enacted, a few minor tweaks around the education revolution, but very little in terms of rocking the boat. A very respectable 2% of GDP in surplus was maintained.

Then the GFC broke. Within weeks, the official pronouncements were that a severe financial cyclone was headed our way with a ferocity that had not been witnessed in a generation. Two rounds of fiscal stimulus were announced in quick succession leaving the coffers with a surplus of merely 1% of GDP (what they were unwilling to say then was that effectively with an expected slowdown, revenue write-downs of more than 1% were inevitable, so the government had already slipped into deficit at that point, but nevermind they thought, the stimulus might actually work).

Then the second round of the budget took place. This time the government literally was willing to bet the house. It went all-in. No such thing as cutting your losses, when the prospects were looking grimmer by the day. It took them a few days to acknowledge that the nation was as a result of its budget staring down a net debt worth a whopping 13.8% of GDP. It had changed its tack from being risk averse, economic conservatives to risk-seeking big-spenders, all in 18 months. Yet, despite all the recriminations it received for trying to spin the deficit negatives into a positive, Rudd and co were merely reacting based on nature’s inbred survival instinct.

The remaining hand

Ironically, political considerations had held them back from considering the full-on risk-seeking decision of cancelling tax cuts to address the structural imbalances in the budget that had crept in as a result of overconfidence on the part of the Federal Treasury in the commodities trade boom. Again from McDermott et al a lesson in economic reform:

An important topic…is the decision by some leaders to implement radical economic reform…(f)rom Latin America to Eastern Europe, leaders like Alberto Fujimori in Peru institute bold economic reforms with severe costs for the population and, surprisingly, receive widespread support for such action. Similarly, leaders such as Boris Yeltsin in Russia and Vaclav Klaus in the Czech Republic were re-elected despite instituting costly economic adjustment plans (emphasis added).

By not addressing the fiscal imbalances in the present budget, the Feds have had to assume a V-shaped recovery; and yet, notwithstanding their optimism it will take no less than 13 years for the “temporary” debt to be erased. With the current talk of long-term bond spreads widening and credit downgrades over the horison (which will lead to higher debt servicing costs), time will tell if this act of hesitance towards reform in the wake of aggressive yet popular spending leads the government and the electorate down the track to a no deal situation.

Humans v Rats v Monkeys

This is a case of how “heuristic bias” in humans (a preference for rules of thumb in decision-making) and hubris proved to be their undoing when pitted against rats and monkeys in two experiments. The lessons drawn have implications for anyone engaged in economic development and industrial policy.

Prominent development economist Bill Easterly was not joking when he recently blogged that “rats outperform humans in interpreting data.” He was referring to the experiment recounted in Leonard Mlodinow book The Drunkard’s Walk in which rats and humans were pitted against each other and made to draw green and red balls at random. With probabilities rigged in favour of greens, they were made to predict the colour of the balls drawn after observing the process.

Surprisingly, the rats came out on top:

The rats followed the optimal strategy of always predicting green (I am a little unclear how the rats communicated, but never mind). But the human subjects did not always predict green, they usually want to do better and predict when red will come up too, engaging in reasoning like “after three straight greens, we are due for a red.” As Mlodinow says, “humans usually try to guess the pattern, and in the process we allow ourselves to be outperformed by a rat.”

This experiment is reminscent of the 14 year exercise initiated by the Wall Street Journal which tested Princeton Prof Burton Malkiel’s thesis contained in the book A Random Walk Down Wall Street that

a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.

After 100 iterations of the game, the results showed that while the analysts came out on top, the margin was embarrasingly low, 61-39. One funny way to express this finding would be to say that when it comes to “picking winners”, “monkey see, monkey do” works fine.

Easterly whose stint in the UN led him to take a dim view of so-called “growth experts” has sparked robust discussions with the likes of Jeffrey Sachs of The End of Poverty fame over the effectiveness of international development projects and Dani Rodrik author of One Economics, Many Recipes over the appropriateness of industrial policy.

In terms of developing growth strategies, Easterly’s advice has been to forego well-intentioned interventions emanating from the top (whether they be the in the form of a "big push" for public investment ala Marshal Plan or "shock therapy" ala Sach's approach of introducing market-based institutions to ex-Communist regimes). Easterly’s most recent book contrasts "planners" and "searchers". The former use the instruments just mentioned to (not) achieve their goals. The latter rely more on local feedback and accountability with

lots of political and economic competition with freedom of choice of consumers, investors, and voters.

The belief is that there is no use second-guessing what works when the local market for ideas performs more efficiently and contains more information than the calculations of a detached planner no matter how sophisticated his heuristic models might be. The fact which all these experts agree on is that public investments and industrial policy may have been partly responsible for economic development in some cases in the past. Where they part ways is on whether experts can identify with any reliability the means with which to implement them in different situations in the future.