NEW YORK ( TheStreet) -- Negotiations to settle the U.S. debt ceiling have entered a new a serious stage with a possible catastrophic outcome of a default on U.S. Treasury bonds. But for analysts and academics, the endgame favors the Republicans.
For many on Wall Street, how the debt negotiations play out over the coming days fits perfectly into "game theory," a specialty of mathematics that studies strategic decision-making. The practice was made famous by the 2001 movie A Beautiful Mind about the Nobel Prize-winning game theorist John Nash, portrayed by Russell Crowe. Game theory is a passion of many Wall Street analysts and hedge fund managers, especially quantitative analysts (or "quants") that use it as the basis for everything from pricing options to trading billions of equity shares every day. But game theory can also be used to study politics, including the current debate in Washington over the debt ceiling and a possible U.S. default. Game theorists agree that the debt-ceiling debate fits perfectly into their realm and many understand which game Washington is playing. "I think the more relevant game analogy here is 'chicken,'" says Benjamin Polak, professor of economics at the Yale School of Management and a noted expert on game theory. Polak explains the chicken can best be described in Rebel Without a Cause starring James Dean. In the movie, two cars drive toward each other and the possibility of a horrific crash. James Dean can choose between "swerving" and remaining unscathed but risking humiliation, or he could remain "tough" and come out a hero but risk death. "The best outcome for each individual player is that they remain tough and the other swerves," Polak explains. "The worst outcome for each player is for neither to swerve." In terms of the debt debate, Polak explains, that would mean the "optimal" outcome for both Democrats and Republicans is that each side compromises and "swerves" to avoid a U.S. bond default. "In terms of game theory, both swerving is a little better than swerving if the other remains tough," Polak adds.
However, the fact that President Obama will wield the ultimate decision on any debt ceiling through a veto puts him at a strategic disadvantage in the default game of chicken, says Nolan McCarty, professor of politics and public affairs at Princeton University and author of Political Game Theory. "Obama will accept a Republican proposal because he is not going to want to be the one with finger on the trigger of default," McCarty says. "Obama has the less good hand, and that will reflect how things turn out. A veto, in game theory, is considered a 'non credible threat.' " The wildcard in the debt crisis that could cause both sides to "crash" are voters, McCarty argues. "The American public is trying to both watch the game and decide who is behaving correctly, and that is complicating matters," he says. "Both sides are deciding how voters will respond, and either side could easily miscalculate." Polak agrees, adding that like all games, "bad outcomes" can happen in the blink of any eye. "If each of us think it sufficiently likely that the other person will swerve, neither of us will swerve. Thus collisions can occur without anyone being irrational or thinking anyone else is irrational." he says. "The main simple lesson of this game is something we already knew from the James Dean movie: You don't want to be playing this game in the first place," Polak adds.