Faculty member in the Department of Managerial Economics & Decision Sciences until 2014
In October 2010, Britain’s parliament announced sweeping budget cuts. Under the new austerity plan, which aims to save $130 billion over the next four years, even Queen Elizabeth will have to tighten her belt. “Today is the day when Britain steps back from the brink,” said U.K. Chancellor George Osborne in his address to Parliament. Entitlement programs such as social welfare were hit particularly hard. The plan also raises the retirement age from 65 to 66.
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In the United States, trimming the budget is proving to be much more difficult. Democrats have agreed to slash $10 billion, but Republicans are asking for $61 billion in cuts. Even that amount would be proportionally far less than the cuts passed in the U.K. To date, Congress has yet to reach a compromise. To avoid a government shutdown, lawmakers passed two stopgap spending bills, giving them more time to come to an agreement.
“We think that the size of government expenditure today is likely to be shaped by the size of government expenditure yesterday.” — Fong
Daniel Diermeier, a professor of managerial economics and decision sciences at the Kellogg School of Management at Northwestern University, and Pohan Fong, a professor at the City University of Hong Kong, have developed a new model that may explain why the U.K. was able to quickly slash its budget while the U.S. is still struggling to make even modest cuts. The model suggests that countries under parliamentary rule might have an easier time cutting back than countries under a presidential system. It also explains why federal budgets expand, but rarely shrink. “We think that the size of government expenditure today is likely to be shaped by the size of government expenditure yesterday,” Fong says.
Why would a government spend beyond its means? Economist John Maynard Keynes argued that in times of unemployment, deficit spending is the only way to restore an economy’s vigor. “There is an economic justification,” Diermeier says. “The problem is that once things get back to normal, you then have to cut the budget again. That doesn’t happen enough.” Countries all over the world have been struggling with growing deficits. In January, the U.S. deficit was at an all-time high of $14 trillion.
Several theories have been proposed to explain why budgets expand. For example, the ruling party might decide to overspend because it increases the likelihood their candidate, the incumbent, will be re-elected. Alternatively, if the incumbent expects to be ousted, he or she has little incentive to spend within the country’s means. There’s also the “common pool” problem. Imagine there’s a pond full of fish. Fishermen who frequent the pond will tend to fish too much today and leave too few fish for tomorrow. That’s because each individual fisherman enjoys all the benefits of over-fishing, yet he bears only a fraction of the cost.
But there is a gap in the theory, Diermeier says. “Traditionally when people look at things like budgets, or public finance more generally, they ask themselves, ‘What are good approaches to make sure that these budgets are more efficient?’” he notes. But, creating the most efficient budget is rarely the top priority. “These budgetary procedures are really implemented by politicians that have their own interests,” he says. “These people interact in a strategic setting, and that setting is driven by the rules of the country’s constitution.”
So Diermeier and Fong set out to create a new model that would capture this political process. In their model, all parties are out to get the best deal for themselves or their constituencies. A single actor—the agenda-setter—has the power to propose a budget. The proposal must be approved by at least some of the other parties involved. For the proposal to pass, it must defeat the status quo—the past budget. Previous models have tended to disregard the status quo, but Diermeier and Fong argue that it’s a key factor. Their model also takes into account not only the total amount spent, but also how the funds are divvied up. Entitlement programs, for example, constitute a large proportion of government spending in many countries. In the U.S., the government spent more than half of its 2007 budget—$1,604.9 trillion—on pensions, health care, welfare and veterans, the bulk of which went to entitlement programs. These programs receive the same funding year after year unless new legislation is passed. “It acts like the default,” Diermeier says. Proposals by both Republicans and Democrats to slash the 2012 U.S. budget leave entitlement programs such as Medicaid, Medicare, and Social Security—which make up 57 percent of the budget—largely untouched.
Baking a Budget
The model is easiest to understand when it incorporates only two players. Imagine that two people work together to create something of value. For the sake of simplicity, let’s pretend they decide to bake a cake, Fong says. They agree to split the cost of the ingredients and also divide up the cake once it has been baked. “The cake can be understood as the total government expenditure, and then different slices of the cake can be interpreted as different spending categories,” Fong says. The cost of the ingredients, of course, would be taxes.
Say the pair wants to bake a bigger cake this year than they did last year, akin to increasing the budget. “In that case, it is easy for us to reach a consensus to get a bigger cake,” Fong says. “As the agenda-setter, ‘I can give you more cake to eat, and then just enough to compensate you for the higher ingredient cost,’” he adds. Both parties pay more, but both also get a bigger slice of the cake. The same is true in the model, where as long as the other player is getting a deal that is at least as good as the one he got last year, he’ll approve the new proposal.
The problem comes when the pair needs to bake a smaller cake. “Let’s suppose that, according to the default, we are going to bake a very big cake,” Fong says. “That’s too much.” So the agenda-setter proposes baking a smaller cake. Initially, everyone is better off because the cost of the ingredients goes down. But imagine that the cake is divided unequally, and the agenda-setter has a large piece while the other person gets only a sliver. Because the agenda-setter is self-interested, he’ll cut the other person’s slice first. But he can only reduce that slice of cake down to nothing. The other person cannot receive a negative amount of cake. To cut costs further, the agenda-setter must reduce the size of his slice. That makes the deal worse for him and better for the other player, relative to himself, so he would be unlikely to propose this solution.
Similarly, if the agenda-setter has the smaller slice, he can reduce his own portion down to zero, but then he has to cut the other party’s slice, a proposal the other party is likely to reject. Only when the cake is divided evenly is reducing the budget a simple proposition.
The cake metaphor is “really a very simplified way to think about the problem,” Diermeier says. In the real world, of course, the “cake” is divvied up between a whole host of actors, all of whom have different interests. That adds complexity to the model.
Next, Diermeier and Fong moved from a two-party system to a three-party system to examine how this model might work in a parliamentary system, like in the U.K., compared to a presidential system, like in the U.S. In a parliamentary system, the agenda-setter—the prime minister—forms a coalition with one of the other players. “You have a permanent coalition between two parties,” Diermeier says. The agenda-setter must receive support for his proposal from that player. But Diermeier’s previous research suggests that the prime minister has a strong incentive to propose a budget that all parties will approve. That tends to create more equality between the players.
Under a presidential system, the agenda-setter—the president—can seek support from either of the other players. “For example, on the issue of cutting down defense spending,” Diermeier says, “you might have a coalition of Tea Party activists—Republican budget hawks—together with some very liberal members of Congress. These coalitions change all the time.” The president will tend to seek the support of the player with the smallest slice of cake—the one most disadvantaged by the status quo—because his vote would be cheaper to buy. That can create greater inequality between the players and leave the agenda-setter worse off. That may explain why, in the current U.S. budget debate, no one seems to want the role of agenda-setter, Diermeier says. “There’s going to be strong political backlash against the proposer of these cuts,” he says. Overall, the model implies that, given the same status quo, a prime minister will be more likely to propose budget cuts than a president, and could explain why the U.K. government has had more success cutting the budget than the U.S.
Even the best model cannot account for all the real-world variables. “Like any type of game theoretical model, it leaves out many complexities,” Diermeier says. For example, the model doesn’t take into account elections. “It’s really a simplified way of capturing how the political process works,” Diermeier says. Still, it illustrates some important points.
Politicians have an interest in keeping the deficit low, but they also have an interest in getting as much as they can for their constituents. “Everybody wants to get some kind of help from the government,” Diermeier points out. “But if you do that then the government budget deficit will just increase.”
Related reading on Kellogg Insight
Diermeier, Daniel and Pohan Fong. 2010. “Bargaining Over the Budget.” Social Choice and Welfare. 36(3-4): 565-589.
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