TCA Srinivasa-Raghavan: The US current account deficit as a Nash equilibrium

OKONOMOS

No country thinks it is going to gain by unilaterally changing its strategy. So we are stuck.

The US current account deficit has become a cause for concern. But is it a cause, as used to be said, for panic? Dr C Rangarajan, who is well-known enough, and A Prasad who is advisor to the Executive Director for India at the IMF, have written in a paper* about it.

It is the old bloated monsoon frog problem, really. What can be done to prevent it from bursting and therefore the resulting mess? Although it is not certain that there will indeed be a US bust, there is enough past evidence to suggest that there could be one. So we need to worry, say Rangarajan and Prasad.

"The consequences of the adjustment "" on exchange rates and interest rates "" that would follow would be unpleasant for the US alone, but for most of developing Asia as well." In practical terms, this means that all countries need to work together to ensure that the frog lives to croak another day. But that is easier said than done because "the patterns of the current account are not homogeneous across nations." This means not everyone might want to prevent a bust equally strongly. In frog terms, a neighbour may well ask, why should I worry if the frog is in your portico?

Not just that, either. "Even if there is broad agreement on the strategy for an orderly unwinding (of the global imbalances) the response by different countries is likely to be uneven in view of domestic considerations." In short, the world is in trouble but because of the incompatibility of incentives across countries, it will not take co-ordinated action to prevent trouble.

The strength of this paper lies in the succinct and comprehensive survey of the important literature on the subject, and the pinpointing of the single biggest problem that needs to be overcome, namely, the absence of compatible incentives across countries to co-operate with each other in bringing about an "an orderly unwinding of global imbalances". The authors call for co-ordinated action but don't think it will be forthcoming.

The Prisoners' Dilemma is implicit in the analysis, with the US playing the role of policeman. The authors say that "the international community agrees that action for orderly a medium-term resolution of global imbalances is a shared responsibility, and will bring greater benefit to members and the international community than actions taken individually", and leave it at that. Thus the paper's weakness lies in the authors not using game theory to analyse the likely strategies that countries may follow. Such an approach would have made the paper richer.

The Prisoners' Dilemma arises as follows. Each country (player) has two options: co-operate or not co-operate with each other. Each country also tries to maximise its payoff without any concern for the others' payoff. Only the policeman (the US) gains as a result because irrespective of what any one country does, the others stand to gain more by not co-operating with each other. Lack of information and trust leaves them all worse off.

There is then the problem posed by John Nash, called the Nash Equilibrium. This says that no player gains by changing his strategy unilaterally. This means that no one changes his strategy, and we get a Nash equilibrium in which there is no incentive to follow a different strategy.

I think this where we are at in respect of the US current account deficit. No country thinks it is going to gain by unilaterally changing its strategy, whatever it might be. So we are stuck until something gives.

Even in terms of domestic policies, where it is necessary to have a strategy for the achieving the right mix of monetary and fiscal policies, a game-theoretic approach might lead to more useful insights, if not actual solutions. This is because there are two players there too: the finance ministry and the central bank, with each trying to maximise its pay-off, whatever it might be at a given point in time.

We have seen in India how they don't co-operate even when co-operation would leave both better off than non-co-operation. Elsewhere also it is the same because of the differing time horizons. Rangarajan and Prasad have discussed the fiscal and monetary options to tackle the US current account deficit in some detail and they come away discouraged.

As for India, they say, since India is not responsible for the imbalance, "no action is required" on its part "as part of a co-ordinated action to reduce the global imbalances (but) action by the US and other countries could create a situation for which India must have an appropriate response."

In short, we had better watch out.

*Global Imbalances and Policy Responses, ICRA Bulletin, Money and Finance ,Jan-July 2006, http://www.icraratings.com/money_finance/Rangarajan.pdf