Thanksgiving is over and everyone is back in D.C. talking about the fiscal cliff – the automatic tax increases and spending cuts to defense and entitlement programs that go into effect if no agreement is reached before January 1. These measures might put the fragile economic recovery at risk so a more nuanced deficit reduction plan would be good to have in place. Will such a plan come out of negotiations in the remaining month?

The Coase Theorem says “yes” in at least two contexts.

In the simplest version, there are deals that both sides prefer to the outside option and we should agree to one of them. For example, neither side wants tax increases for people on incomes below $250k as the consequences are bad in primaries and general elections. So they could agree to replace the fiscal cliff contract with one that simply deletes the tax increases on those earning less that $250k.

This simple version assumes that the fiscal cliff measures are enforced if there is no agreement but this is surely not the case. The measures would be the starting point for renegotiation and hence the endpoint of the renegotiation is the benchmark with which to compare proposed current deals. As in Jeff’s earlier post, the negotiations would take the form of  a “war of attrition” and we could end up in an equilibrium that destroys surplus. But as long as we play an equilibrium of the war of attrition, again the Coase Theorem goes through with the expected payoffs in the concession game as the outside option.

In a similar vein, many commentators suggest that Obama would be in a stronger bargaining position once we go over the fiscall cliff. Hence, he should go over it rather than come to a deal ex ante. But this argument does not completely make sense: Republicans also know that Obama would be in a stonger position if we go over the cliff. They also know that going over the cliff has dangerous consequences for them electorally. Hence, there are agreements both sides can come to now that take into account the President’s stronger bargaining position after Jan 1 – as long as they have common expectations.

So, there are two reasons why we might go over the fiscal cliff.

First, many strategies can be rationalized in the concession game after we go over the fiscal cliff. There is no reason why Democrats and Republicans should have common knowledge of strategies. If they hold out for inconsistent deals, we will go over the fiscal cliff. Thus is the “non-equilibrium” interpretation.

Alternatively, the two sides each have private information. How confident does the President feel after winning re-election? How much pressure is he under from the liberal wing of the Democratic party? On the other hand, how much pressure is Boehner under from the Tea Party wing? What is the Chamber of Commerce saying to him about willingness to accept a higher probability of recession to avoid higher tax rates? What is each side’s willingness to bear the electoral consequences of going ovet the cliff? Each side has private information. This is the Myerson-Satterthwaite version of the problem. If there is no mutually acceptable bargain for the most confident type of Obama and the most confident type of Boehner, we will go over the fiscal cliff with positive probability.

The last two theories seem quite realistic so there is positive probability of going over the fiscal cliff.