Cheap Talk

Republican leader, Senator Mitch McConnell, opposes the current version of the financial reform bill.  He claims that the bill generates “moral hazard” by creating a fund that bails out banks if they fail:

Mr. McConnell has framed the Republican opposition as an attempt to prevent future bailouts, and has specifically criticized a $50 billion fund, to be created with a tax on banks, that would help cover the costs of dealing with failing firms in the future. Mr. McConnell said the mere existence of the fund is an invitation to banks to take on risk that could lead them to fail. The White House does not support the fund, which is being pushed by Congressional Democrats.

Democrats have countered that the fund is intended pay for dismantling such firms and putting them out of business – and that setting up in advance would help ensure that the financial industry, rather than taxpayers, would cover the expense of future failures.

Note that the White House does not support the fund either and recently advised the Congressional Democrats to ditch the provision from the bill.  As far as I can tell, the White House view is that the fund is too small and its existence would complicate efforts to raise extra money should it be needed.   If McConnell is right, a bigger fund would exasperate the moral hazard problem so the White House’s preferences would make things even worse.

Also, the Democrats’ faith that firms would be dismantled if they fail may turn out to be mistaken.  The same executives who get their firm in trouble by taking risky bets are in the best position to disentangle them if they go bad.  That’s what happened with A.I.G.

All that leaves just one feature of the current bill to discuss: the fund is to be created by taxing financial firms in good times to help them out in bad times.  Depending on how the tax is designed, it can mitigate risk-taking.  The tax would have to affect the marginal incentive to make a risky bet and cannot be a lump-sum tax.  A successful tax would basically work by decreasing the upside to a trade to compensate for the fact that the firm is insured on the downside by the fund.  This brings up the whole question of what the optimal incentive scheme might be.  I was puzzling about this but then I realized I was trying to reinvent the wheel.  Much attention has already been paid to these issues in the finance literature and our very own Jeff Ely linked to a blog where Eric Maskin gave his five recommendations for great papers to read for guidance about the financial crisis.

To summarize some of the main points:  Banks must take equity in the bets they take to reduce moral hazard and this may have to be regulated (Holmstron and Tirole).  Depositors and small shareholders do not have good incentives to monitor so the government may have to set capital requirements to substitute for them (Dewatripont and Tirole).  Tight monetary policy can be used reduce the profitability of lending, much like a tax.  There are lots of other points but they are less relevant for the topic of this post.  I have not read a couple of these papers myself (eg Kiyptaki-Moore) but I intend to!

There are lots of other ideas floating out there (Volker rule, breaking up banks, reinstating Glass-Steagal).  Which is truly the best is hard to say.  But the basic principle is clear: If banks are going to be bailed out as a bank failure would cause systemic risk, they do have the incentive to take on riskier bets (let’s call this the “McConnell effect”).  Then, there has to be a countervailing effort to reduce the upside of risky bets (let’s call this the Olympia Snowe/Susan Collins/Scott Brown effect as we know who’s in the driving seat).

This brings me to my final point: While such a policy is designed for the long run, it will create pain in the short run.  Banks are pretty reluctant to lend right now (I assume?).  They do not need a tax to dis-incentivize them.  They may need the reverse.  How does financial reform deal with this?  Do we delay the implementation of the restrictive legislations?  This would create the incentive to invest and lend now rather than delay if profits from future lending are going to be taxed.  Probably there is some old finance paper that already discussed this too!  But I do not know it.

1. Twitter’s plan to make money.
2. The herb that even Julia Child would pick off her plate and throw on the floor.
3. Some valuable thoughts on Fair Trade coffee.

It’s always nice when you get a comment from someone you recognize but do not know personally.  So it was a nice surprise to see that Andrew Gelman left  a comment on my earlier post and then wrote his own blog post.  Andrew says:

[I]f this “cheap talk” is useless, why it’s done at all! Or, conversely, why it wasn’t done earlier. Baliga’s analysis seems to me to rely on there being some “suckers” somewhere who don’t realize what’s going on.

Perhaps, for example, the leaders of Iran, Russia, etc., aren’t fooled by the cheap talk.–after all, they run countries and have incentives to understand the relevant signaling–but maybe it could sway American voters, who don’t have the time and inclination to gain a deep understanding of power politics. But . . . if it could fool the voters, it could change U.S. policy, and in that sense the stated policy does mean something. Beyond this, there are default effects and status quo effects and costs to violating or altering a stated policy. So I don’t think such public statements are necessarily meaningless, especially considering the many players involved in policymaking in any country.

On the other hand, I know next to nothing about international relations, so I could well be missing something important. I don’t see Baliga’s conclusions as following from basic game theory but maybe there’s something about this particular setting that changes things.

I was a bit terse in my original post and the concept of “cheap talk” is confusing so let me have another stab at an explanation.

Cheap talk is a costless message sent before a game is played.  Since it is costless, you might think it never has an impact.   That turns out not to be true. But whether and how cheap talk has an impact depends on the game that’s played after the talk.

The simplest and most famous scenario is where the game just involves a decision made by one player, the receiver (this is the famous Crawford-Sobel model).  In the background, there is some uncertainty and the receiver would love to fine-tune his decision to the underlying state.  If he does not know the state, the receiver makes a decision which works out on average and this is the equilibrium of the game without cheap talk.  Now add  a player, the sender, who knows the state and whose preferences coincide exactly with the sender’s.  Let the sender send a message before the receiver makes his decision.  The sender has perfect incentives to tell the truth, so the receiver learns the true state in equilibrium and cheap talk works.  That is, the equilibrium set of the game without cheap talk is different than the game with cheap talk.  Hence, cheap talk can be effective even if it is costless.  It does not require the existence of suckers.  And cheap talk is useful as it helps the two players to some to the best decision in each state.  (Actually, Jeff has already written about this game.)

But in the nuclear proliferation scenario I claim cheap talk is not useful.   I copy my initial response to Andrew:

But there is one key case where cheap talk is useless even in games of incomplete information: when a player i’s preferences over player j’s actions do not depend on player i’s preferences. In the nuclear story, this arises if the player i prefers that player j not acquire nuclear weapons, whether player i is itself rapacious, conciliatory or something in between. Then, player i will always send the message that minimizes the probability that player j arms and cheap talk cannot be informative.

As  player i sends the same message whatever his preferences, his message contains no information.  Hence, the equilibrium set does not change compared to a nuclear proliferation game with no talk preceding it.  Whatever player j’s optimal plan was in the game without cheap talk, it remains optimal with cheap talk.  Some message is sent in any case – even saying nothing is a message.  There will always be some message, like it or not, once you allow cheap talk before a game.  The question is whether it is effective and I claim it is not in my visualization of the nuclear proliferation game.

My analysis is a rational choice analysis, as is analysis in basic game theory.  It assumes in particular that Iran is rational.  This means they can do backward induction and think through Obama’s strategic incentives to send messages.  Then, they can deduce that he always has the incentive to minimize their probability of acquiring weapons whether he intends to be belligerent, conciliatory or not.  So, there is no information content in the message as the same message in sent in all cases.

Gelman makes the point that if voters can be fooled, cheap talk may be effective.  Also, if Iran is fooled, cheap talk is also effective.  This latter possibility is the hypothesis that makes sense of the new nuclear policy in the simplest way – if Iran accepts Obama’s message at face value, it might stop pursuing nuclear weapons.  If Obama believes that Iran is naive, he does want to send the message.  But, as Andrew suggests, the idea that Iran would be caught out is implausible.  If even if Obama believes there is small chance Iran/North Korea is fooled, he may send it anyway – after all I claim the policy has no impact anyway if Iran is rational but if it makes things better with a small probability, why not?

Andrew’s idea that voters might be fooled is plausible and his post built around this idea.  (Somewhat confusingly, he suggests I am assuming there are suckers in the model but I think his idea requires them while mine is a rational choice analysis.) But anyway, till we have a good theory of how to fool voters, it is hard to judge how the change in nuclear policy affects nuclear proliferation.  If voters think Obama’s policy is a softening of the previous policy and will embolden Iran, as the Cheneys will say, voters may think Obama is weak.  Then, Obama may have to signal he is tough by acting tough, not just talking tough.  So fooling voters is bad for Obama in the end and he is a sucker too in this scenario.  Or we can go the other way and say voters will increase support for Obama as he is a smart foreign policy guy and will reduce nuclear proliferation.  Then, the Obama strategy makes sense.  We can send the analysis anyway we want by adding players who can be fooled into the story.

But there is an insight to the basic game theory analysis – why might communication not work?  It would be good to understand that before moving on to add naive voters, status quo effects and the like.

1. Princess Leia meets Jerry Garcia
2. The gift card multiplier
3. Fox News firing on all cylinders

My former colleague Oprah Winfrey reportedly resigned once the grading of  term papers got too much for her.

Luckily, for busy Oprahs and slightly less busy Baligas and Elys everywhere, capitalism has come up with a solution – outsourcing of grading to India:

1. Possible future Prime Minister  and Chancellor of Exchequer of Britain in earlier days.  A Who’s Who for the David Cameron photo.

2. Of course, it’s hard to join the Bullingdon Club.  But you can approximate their social and dress codes (y-updated).

1. WTF1: The gene that makes you gullible.
2. Distressed Assets?

Growing up in California I didn’t get much experience driving in the snow and I had a steep learning curve when I moved to Chicago.  So it’s pretty important to me to make sure that my kids get an early start.  My 3 year old made a lot of progress with his driving lessons last fall and so I wanted to strike while the iron was hot and get him out on the road in some snow this winter.

There are certainly some new challenges involved.  For safety reasons I wanted him to learn in a car with all-wheel-drive.  Only my car has that, but my car is a manual transmission.  He’s a big boy but still its a big reach down to that clutch.  We figured out that he could see a lot better with a simple convex mirror held at just the right angle.

It takes a lot of practice to do that and shift gears quick enough to get his hands back on the steering wheel, so we had to start early before the big snows hit to make this transition as smooth as possible.

Another big issue with driving in the snow of course is that the car can easily get stuck, especially when you are just learning.  Before I’m going to let him take the wheel in a major snow storm I want to make sure he knows how to get the car out of rut when necessary.  We are firm believers in teaching our children to be self-sufficient. So we practiced this a lot.

As with every big milestone in a child’s life, there were many ups and downs.  Not to mention some real nail-biting moments as you would expect.  So you could imagine our pride and emotion when he was finally ready for his first solo ride. (Click here to see video if you are using google reader)