Prospect Theory and the Looming U.S. Government Default

As we approach the entirely real possibility of the United States defaulting on its debt, I’ve been trying to wrap my head around the behavior and strategy of the less respectable Tea Party members in Congress. What’s clear to nearly everyone is that the Tea Party’s gamble has backfired. What’s clear to nearly no one is why they have yet to notice that their strategy is a losing one. The irrationality of it all is enough to make you laugh… through gritted, angry teeth.

Only recently, I’ve found myself thinking back on behavioral economics, that love-child of Psychology and Microeconomics that tries to describe how actual humans make decisions. Behavioral economics did away with the fundamental assumptions of the microeconomic field, that is that humans are entirely rational creatures. To anyone outside of economics, this may seem obvious, but for many reasons, including an extremely successful theory built on this premise, the idea persisted much longer than it should have. Enter behavioral economics, and with it, prospect theory, which is an attempt to describe how humans deviate from rationality when making decisions.

Prospect theory puts forward two fundamental ideas about human decision making that are relevant here:

1. We fear losses more than we seek gains.

2. We overestimate very low probabilities.

These two observations lead to the chart below, known as the Four Fold pattern.

Four Fold Pattern

The chart illustrates a few obvious points.  If you are given a choice between a  95% chance of winning a large amount of money (top left box) or 100% chance of being given a  lower amount, you become afraid of coming up empty on the gamble (because you overestimate a 5% chance of loss) and are very likely to take the sure thing.  The bottom right box illustrates a similar case, however, in this case your choice is between a 5% chance to lose a large amount and a sure loss of a much lower amount.  Because you fear losses so much, you accept a settlement for a guaranty of loss of less money.  Many civil court cases end in exactly this manner.   In both of these boxes, you seek the comfortable choice, and certainty wins out.

The truly interesting cases lie on the other diagonal, the situations in which you become a risky decision maker.  In the bottom left hand box, your choice is between a very low probability gamble with a large payoff, or a %100 chance of gaining a much smaller amount.   Because we deviate from rationality, we overweigh the low probability of winning, and so reject a favorable settlement in search of the possibility of the large gain.  Entrepreneurs are familiar with this box.

But the most interesting box is the top right box.  The situation described here leads to behavior that is by all accounts completely unintelligible for a person who observes the situation from an emotionally disconnected standpoint.  In this situation, you are facing a choice between a very high probability of losing a large amount, or a certainty that you will lose a smaller amount.   Your chance of losing should you take the gamble is almost certain, but not entirely.  Instead of making the rational favorable choice (a sure loss but for a lower amount), you take a risk and pursue the uncertain choice.  You fear the losses enormously, and there still remains some hope that you won’t lose anything at all if you gamble.  Most of us recognize this for what it is; we call this desperation.

 You can think about this in terms of normal economic exchanges, with gains and losses being in terms of money.  Or alternatively, we can think about it in terms of more abstract political gains and losses.  When considered in this way, the behavior of the Tea Party suddenly becomes clear.  The truth is, they aren’t blind to their predicament.  The Tea Party has two options, accept defeat and relinquish their hold on the debt ceiling, accepting whatever damage they have already done to their brand.  Or, alternatively, they can take a risk and push the President and the Democrats to the very deadline, on the miniscule chance that the Democrats will cave-in and deliver all of the concessions that the Tea Party demands.  Of course, the chance of this happening is almost nil.   The Democrats will almost definitely not cave on the demands, it’s more likely that their fellow Republicans will cave, and the results for the Tea Party brand will be catastrophic (at least in their eyes).  But as we see above, the size of the probability doesn’t  matter.  The only thing that matters is that there exists a possibility.

In this context, the strategy of the Tea party is clear.  It’s not rational, but it’s deeply human.  The problem for them is that their gamble on the debt ceiling is a gamble for all of us, most of whom would rather swallow the sure deal.  We want certainty.  Instead, fear, pride and desperation guide the day.

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