Dynamic Collective Choice with Endogenous Status Quo∗

Dynamic Collective Choice With Endogenous Status Quo Wioletta Dziuday Antoine Loeperz August 2014 First version: December 2009 Abstract This paper analyzes an ongoing bargaining situation in which preferences evolve over time and the previous agreement becomes the next status quo, determining the payoffs until a new agreement is reached. We show that the endogeneity of the status quo induces perverse incen- tives that exacerbate the players’ conflict of interest: Players disagree more often than they would if the status quo was exogenous. This leads to ineffi ciencies and status quo inertia. When players are suffi ciently patient, the endogenous status quo can lead the negotiations to a complete gridlock in which players never reach an agreement even though their preferences agree arbitrarily often. When applied to the legislative setting, our model predicts partisan behavior, and explains why oftentimes legislators fail to react in a timely fashion to economic shocks. JEL Code: D72. Previously circulated under the title “Ongoing Negotiation with an Endogenous Status Quo.”We thank David Austen-Smith, David Baron, Daniel Diermeier, Bard Harstad, and seminar participants at Bonn University, Leuven University, CUNEF, Northwestern University, Nottingham University, Rice University, Simon Fraser University, Universidad de Alicante, Universidad Carlos III, Universidad Complutense, the University of Chicago, and the Paris Game Theory Seminar. Yuta Takahashi profided an excellent research assistance. yCorresponding author. Kellogg School of Management, Northwestern University, 2001 Sheridan Road, Evanston, 60208, IL. Email: [email protected] zUniversidad Carlos III de Madrid. Email: [email protected] 1 1 Introduction The legislative gridlock that paralyzed the 112th U.S. Congress and led to a fiscal cliff highlighted the inability of legislators to agree on much needed fiscal policy reforms, in particular concerning the various entitlement programs such as medicare and social security. This gridlock puzzled the popular press and public, who bemoaned the partisan behavior of the legislators and interpreted it as blind allegiance to their parties and ideologies. The economic literature has proposed several ra- tional explanations for the inability of legislators to reach seemingly beneficial agreements: electoral calculus, vested interests, uncertainty over the distributional impact of reforms, lags in the effects of reforms, or communication failures.1 This paper shows that partisan behavior and legislative inertia can be the strategic consequence of two features. First, many bargaining decisions such as the laws that determine entitlement programs are continuing in nature. That is, they remain in effect until a new agreement is reached. Second, a constantly evolving environment requires these decisions to be periodically revisited. To understand how the combination of the continuing nature of policies and the evolving environment leads to excessive disagreement, consider the case of legislators negotiating over the level of fiscal spending. During a contraction, generous deficit spending may be favored by all parties to stimulate short-term economic growth. During a boom, all parties may agree to use the extra tax revenues to bring the public debt under control. In normal times, however, legislators may genuinely disagree on the optimal level of public spending. If today’s policy becomes the default for future negotiations, fiscal conservatives may be reluctant to increase public spending during a recession, out of fear that their liberal counterparts will veto a return to fiscal discipline when the economy improves. Similarly, anticipating future disagreement, liberals may refuse to lower spending in times of economic growth, out of fear that conservatives will oppose a fiscal expansion when the boom is over. We first formalize this insight in a basic model in which two players engage in an infinite sequence of choices over two alternatives, called L and R. At the beginning of each period, one alternative serves as the status quo. If both players agree to move away from the status quo, the new agreement is implemented. Otherwise, the status quo stays in place. In both cases, the 1 See Section 2 and Drazen (2002) for a detailed review of this literature. 2 implemented agreement determines the players’payoffs in this period and becomes the status quo for the next; that is, players operate under the endogenous status quo protocol. Players’preferences change over time in a stochastic fashion. We assume that players preferences over the alternatives sometimes disagree, and whenever they do, one player (the rightist) prefers R and the other (the leftist) prefers L. We show that indeed the endogeneity of the status quo exacerbates the players’ conflict of interest and leads to equilibrium behavior that resembles partisanship: in all equilibria, the leftist player votes for L and the rightist player votes for R more often than they would if the policies were not continuing in nature or if there were no shocks to the preferences. As a result, players may fail to reach an agreement even when the status quo is Pareto dominated. Hence, the status quo stays in place too often, and the bargaining outcome is less responsive to the environment. Our analysis further shows that players’ equilibrium behavior is driven by a vicious cycle in which partisanship and disagreement feed on each other: more partisan players disagree more often; more frequent disagreement increases the importance of securing the favorable status quo; and this further increases partisanship. As a result, the polarizing effect of the endogenous status quo can be quite dramatic. In particular, we show that the negotiations can come to a complete gridlock: even if their preferences agree arbitrarily often, suffi ciently patient players never reach an agreement, and the bargaining outcome is completely unresponsive to the evolution of preferences. When players bargain over more than two alternatives in each period, the polarizing effect of the endogenous status quo can be accompanied by other equilibrium effects which depend on the fine details of the model. Their complex interaction makes it hard to isolate analytically the impact of the endogenous status quo on equilibrium behavior. However, our analysis delivers two important insights. First, these additional equilibrium effects arise only for a particular allocation of bargaining power, while the polarization effect is independent of this allocation. Consistently, we show that for a class of bargaining procedures– which has been found to be of particular empirical relevance in Riboni and Ruge-Murcia (2010)– only the polarization effect occurs, and the endogenous status quo generates partisanship and status quo inertia in all equilibria. Second, for the allocation of bargaining power to matter, and thus for the other equilibrium effects to arise, the environment must be able to change drastically before players have an opportunity to react. Consistently, we show that irrespective of the details of the bargaining procedure used in each period, when players 3 can revise the status quo as soon as the environment makes it inadequate, the polarization effect dominates, and equilibria exhibit status quo inertia. Our model is institutionally sparse, but can shed light on a vast array of dynamic bargaining situations which feature an endogenous status quo and shocks to the environments. For example, about two-thirds of the U.S. federal budget– called mandatory spending– continues year after year by default, and legislators’preferences over it are affected by shocks such as business cycles, changes in the country’scredit rating, or the vagaries of public opinion. Recurrent delays in political action have led many macroeconomists to consider fiscal policy as a very imperfect stabilization tool if left to politician’sdiscretion. Our results provide a strategic rationale for the inability of ideologically polarized legislators to react in a timely fashion to a changing environment. Our model also applies to other legislative policy domains. For instance, the laws regulating civil liberties and privacies, are typically continuing in nature. At the same time, citizens’and legislators’preferences are affected by shocks such as terrorist attacks, national security threats, and technological innovation. Our results also have implications for monetary policy making. In some countries, monetary policy is set by a committee with heterogeneous preferences and beliefs, and the interest rate stays the same until the committee agrees to change it according to its internal voting rule (see Riboni and Ruge-Murcia 2008). Our results show that the endogeneity of the status quo, and the voting rule used in monetary policy making, can affect the ability of the committee to respond to economic shocks. Similarly, the renegotiations of ongoing contracts such as trade agreements, international treaties (e.g., for the World Trade Organization or the European Union), and financial or labor contracts are usually conducted in the presence of a binding previous agreement.2 The impossibility of making these contracts fully contingent on all economic shocks and political events creates the need for frequent renegotiation. In the case of labor contracts, the intuition highlighted in this model suggests a possible explanation for wage stickiness: During a recession, lower wages may leave the workers and the employers better off, thanks to a lower risk of bankruptcy and layoffs. Yet, the workers

Load more