The Hindu Business Line : The G-20 and John Nash

John Nash, the mathematician who won the Nobel Prize for economics, laid down the conditions for successful cooperation. They are impossible to fulfil except for short durations, says T. C. A. SRINIVASA-RAGHAVAN

For several years now, I have been arguing with the few who do not regard me as a complete bore, that economists have lost their way. Many others hold this view, of course, but for differing reasons.

My own reason is that the overemphasis on empiricism, and the obsession with macroeconomics, has led to a near-complete neglect of some of the other disciplines of reasoning which can explain likely outcomes better. Consider, in this context, the G-20 meeting, now under way in Washington.

For one thing, the timing is all wrong — George W Bush can’t make any binding commitments. Nor is he likely to be called upon to do so.

But there are several other powerful reasons as well why the meeting will yield a big fat zero. The most important of these has to do with the logic of cooperative behaviour. The topic has been studied for over 160 years and, thanks to the sheer brilliance of the men who studied it, led to some very important conclusions.

Nash equilibrium

The most important of these men is John Nash, a mathematician, whose work was first adopted and then extensively adapted by economists. In 1951, extending work done earlier, Nash made what now seems like a simple point — but which required some heavy-duty maths.

This was that when several people (or nations), who intrinsically believe that they gain only at each other’s expense, chose to cooperate their cooperation will continue only for as long as one of them does not begin to think that he or it will gain more by not cooperating. This came to be known as the Nash Equilibrium, for which he received the economics ‘Nobel’ in 1994.

It consists of being able to devise a strategy or set of strategies where no one player has the incentive to unilaterally change his own strategy. Also, a key requirement for cooperation is that everyone must know the other participants’ strategy or strategies.

But this knowledge, which is so essential for cooperation, also leads to another question which each player would eventually ask himself: Now that I know what the others will and will not do, will I gain by breaking the rules? If the answer is yes for even the most miniscule change in a player’s strategy, that player will change his or her strategy. We see this happening everyday, everywhere. The key point about this was not that there will never be any cooperation but that it would break down very soon.

What’s worse, such abandonment would necessarily take place because, by definition, cooperation yields less than the maximum possible payoffs for each individual player. So even if they maximise the collective payoff, individually there is always an incentive to break ranks, either singly or in a sub-group. We see this happening all the time, as well. Constituents of ruling coalitions nearing an election provide an excellent example.

External enforcer

There is another reason that militates against long-duration cooperation: For the system to work, cooperation has to be voluntary and self-enforcing. The practical problem begins with the obverse of this, namely, that for continued cooperation there must be an external enforcer.

In the context of global financial architecture, which is what the G-20 is discussing now, this is a crucial element. Until 1971 when the Bretton Woods system broke down, the external enforcer was gold. This was because there could, in theory at least, only be as much paper money as could be backed by the amount of gold available with the world’s central banks, or at least a manageable multiple of it.

Between 1944 and 1971, the US promised to pay everyone who had dollars in gold at the rate $35 per ounce of gold. But so many dollars accumulated with foreigners that the US broke ranks for the reason stated above. It changed its strategy unilaterally saying it didn’t have enough gold!

Gradually, thanks to its economic and military power, it became the enforcer of the new system in which the dollar replaced gold as the currency of international confidence, at least in the non-Soviet economies. The Soviets still preferred gold, as did India.

But now that even that system is close to breaking point, the trillion-dollar question before the world now is whether the US can (should) continue to be the enforcer or does it need to be replaced? All the talk about ‘democratising’ the Bretton Woods institutions is just this: How to replace the US or at least reduce its power.

Who will take over?

But even if it is desirable to do so — and I don’t think it is because the US remains the country with the most power, both militarily and in terms of knowledge and the two will combine to produce economic power — who will take over? China? Japan? India? Korea? Haiti? Since the others can’t agree on who they want to be the enforcer, they are canvassing collective decision-making. But that, as we all know, is as good as having no enforcer.

One result, of course, is that for the foreseeable future, since no one can agree on, or has the power to force upon others, a new arrangement, the US will continue where it is: in the saddle.

In that sense, the G-20 meeting reminds me of vultures gathering around a sick lion but not having the power to attack it. Or, as economists would put it, the current disequilibrium and distortions will persist, and world leaders and bureaucrats will continue to have pointless junkets at the taxpayers’ expense.

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The G-20 and John Nash