Sunday 7 April 2013

Strategic Delegation and the Cypriot Financial Crisis

An interesting thing happened in the eight days between the ‘first’ Cypriot rescue plan was announced on Saturday 16th of March and the ‘second’ plan was announced on Monday 25th March. The Cypriot parliament voted down the first plan, rejecting the levy on deposits and sending the President back to the negotiating table. But it also voted to allow the President to make a new agreement, which could include a bank levy (renamed as a 'restructuring'), and which would not need further Parliamentary approval. This is a noteworthy event: the Parliament relinquished its own decision-making ability. In a situation where the stakes are so high, for a powerful actor to give up its own power is, on the surface, quite shocking.

Why did it happen? It seems to be a textbook case of strategic delegation. The idea of strategic delegation was introduced by Thomas Schelling in his seminal 1960 book, The Strategy of Conflict. Schelling’s work highlights something that, from the perspective of economics, is paradoxical: having one’s choices restricted is sometimes a good thing. In traditional economics, freedom to choose between more options is never a bad thing, as each option may lead to a better outcome. Schelling shows that in multi-agent negotiations, less choice is sometimes better.

When our negotiating opponent makes their choice based on what they expect us to do, it can be an advantage to have very limited options. As a result, it can be beneficial to commit oneself to a particular course of action before the strategic interaction even begins – and let the opponent react. The classic example of this is set in a military conflict: a defensive force ‘burns its bridges’ to cut off its means of retreat. Realizing that the defensive force cannot retreat, and preferring to avoid a fight to the death, the attacking force does not advance. In Schelling’s terminology, the defensive force has made a credible commitment to stand and fight, and this in itself is enough to win the day.

Schelling identifies two uses of a bargaining agent. The first is to pre-commit oneself to a course of action, as in the burning of bridges strategy above. The second is to gain from using an agent whose incentives differ from one’s own.

When the Cypriot Parliament delegated power to the President, it was a highly strategic maneuver. They knew that the resolution of the crisis would require accepting a bailout, and that negotiating the bailout would require painful sacrifices be made on behalf of the Cypriot people. They realized that while they might privately support an agreement that causes pain, there is a high chance that in a public vote a painful agreement would, again, be rejected. The Parliamentarian’s objective is to make a decision that is popular, so they have an incentive to not be seen to support a bank levy. They chose to ‘bind their hands’ to prevent themselves from interfering in the future. The President, by contrast, had the overwhelming incentive to resolve the crisis, so he was appointed as an agent, and, ultimately, a scapegoat who could take the blame for an unpopular agreement.

To some, Game Theory is easy to dismiss as a parlor trick, a mathematical abstraction with little relevance for the real world. However the work of Thomas Schelling illustrates just how relevant it is to every moment of every day – hence why he won the Nobel Memorial Prize in Economics in 2005. Much of his work was inspired by the tension of the nuclear arms race and potential for Mutually Assured Destruction. In a world once again threatened by nuclear conflict, we could do worse than to revisit Schelling’s classic work to help us make sense of the situation.