The heavy cost of holding out

Rohan Pitchford.

Rohan Pitchford. Photo by Belinda Pratten.

Economic theorist Professor Rohan Pitchford is using game theory to understand the thorny problem of sovereign debt defaults. By STEPHEN GREEN.

Two wild animals fight over a piece of meat. On the one hand, the prize; on the other hand, the effort each of them expends in fighting over it. It’s winner-takes-all, loser-gains-nothing-but-exhaustion. The longer they continue fighting, the greater the costs. What is the likely outcome of this situation?

This is a typical scenario in game theory – the study of strategic interactions between rational decision makers. It’s a game called the ‘War of Attrition’, a contest in which, ultimately, winning becomes everything.

Surely, we say, it would be better to give up before the cost gets too high, or agree to share the meat between them? But history tells us that this is easier said than done – think of the trench warfare of World War I, for instance.

Why is it that such situations lead to apparently illogical conclusions? Game theory has helped to show on many occasions that there is, in fact, perfect logic in seemingly inexplicable decisions. These lose-lose stalemates are a result of each ‘player’ acting purely in their own self interest.

Let’s return to our two warring animals. At any stage of the fight, each animal is faced with a choice – fight on, or give up. If each player backs itself, the most likely outcome is that they will keep fighting until one of them gets the meat. Why? Because at any point in the process, fighting a little bit longer and harder to win is better than the alternative – slinking away with nothing. The fact that enormous amounts of energy have been expended to get to that point becomes irrelevant. It’s an example of what economists refer to as ‘sunk costs’. Even if the costs have been enormous, the choice remains – walk away with something, or walk away with nothing.

Games such as the War of Attrition have wide-ranging relevance in evolutionary biology, business, economics and military strategy.

Professor Rohan Pitchford of the Research School of Economics at ANU is an economic theorist working in the area of applied game theory. He looks for ‘canonical’ problems – theoretical scenarios with, he hopes, multiple real-life applications.

“What often happens is that you have an applied problem, and you initially think it’s pretty specific,” he says, “ but then you realise there are actually five other applications in different areas – there is this underlying common phenomenon.”

Professor Pitchford recently teamed up with sovereign debt specialist Mark Wright of the University of California, Los Angeles, to apply a game theory model to the problem of delay in sovereign debt negotiations when a debtor has defaulted on its repayments, just as Greece did last year.

“Such a situation can involve frustrating, seemingly counterproductive delay and typically takes years to resolve – eight years or so for a typical default,” he says.

“This delay occurs as each creditor ‘holds out’ for a better deal – a better repayment plan, if you like. The creditors wait for a potentially better outcome. While they wait, the balance of rewards over costs is whittled down to zero.
Since the parties on the other side are nations, the costs of delay can have serious effects on public welfare.”

Is there a policy that can encourage parties to settle more quickly?

Pitchford and Wright looked at one such strategy – Collective Action Clauses (CACs). These work by closing down holdouts when a majority (typically two-thirds) of the creditors reach agreement with the debtor country. On the face of it, such a mechanism should help limit the delays caused by strategic holdout, but, as a policy solution for sovereign debt, the researchers found it could actually exacerbate the problem, particularly if the agreements involve complicated restructurings.

“We compared CACs to the current free-for-all situation and found that it could actually slow things down,” explains Pitchford.

“The reason is that the first people to move incur a lot of costs in organising the collective getting together to actually come to an agreement. People are asking themselves, do I really want to incur all these costs by being an early adopter? Is the prize really worth it? So this is just another holdout problem replacing the free-for-all problem.”

And we’re back to square one.

This holdout problem is an example of another well-known game theory scenario – the ‘free rider problem’. Each participant delays contributing to a collective action in the hope that someone else will pick up the cost – so they can get the benefit without the price.

“Ultimately, it boils down to a balance between the cost of implementing CACs and the amount that creditors give up in renegotiating the debt – what is known as ‘taking a haircut’,” he says.

“If the restructuring process is complicated, the effect could in fact be to create further delay. The implication is that for CACs to work they need to be simple and offer a benefit that outweighs the cost of delaying. Whether or not this is actually achievable is still open to debate.”

What game theory continually reminds us is that understanding the strategic implications of a scenario can be crucial in formulating effective policy, or simply securing your next meal.


Updated:  25 March 2013/ Responsible Officer:  Director, SCAPA/ Page Contact:  Director, SCAPA