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Behavioral Finance And The Fiscal Cliff

In a famous experiment that helped lay the foundation of the burgeoning field of behavioral finance, Nobel Prize winning economist Daniel Kahneman and his late colleague Amos Tversky examined how people react to offers that seem unfair but are actually more beneficial to all involved than the alternative. There would seem to be eerie parallels between this study and the budget standoff in Washington and the surprising results of the experiment could have unnerving ramifications for the looming fiscal cliff situation.

In an experiment called the Ultimatum Game, a subject is given a certain amount of money which he or she has to split between themselves and another person. The only catch is that the second player can veto the offer, in which case neither player receives any money. Logically, the second player should accept any offer, since surely that's preferable to receiving nothing at all. However, psychologists have found that people overwhelmingly reject small offers that they find insulting and would rather receive nothing than be perceived as having been taken advantage of.

This willingness of people to engage in mutually assured destruction could be cause for concern as we approach the fiscal cliff. If neither side is willing to negotiate over the details of their plans, any offer made by either side amounts to the take it or leave it proposition of the Ultimatum Game. This should make you nervous considering the results of the experiment, especially in politics where perception often becomes reality. The President and House Republicans certainly don't want to appear to have accepted a raw deal, so they might seriously entertain the option of rejecting any seemingly unfair deal, even ones that are preferable to the alternative of going over the cliff and further retarding the already stagnating economy.

Interesting, another aspect of Kahneman and Tversky's Prospect Theory comes into play as to why both sides might make outlandish offers than have little chance of being accepting in the first place. They discovered a phenomenon called "anchoring" where people tend to be subconsciously influenced by the first number they see in negotiations. If they are exposed to large numbers, their initial offers or estimations tend to be high, and visa-versa. In negotiations, it turns out to almost always be beneficial to lay out your position first with a lopsided, even outrageous, opening offer. This causes the other party to become "anchored" to that number and see alternatives as improvements, even if they are much higher than they ever would have considered before being exposed to the "anchor".

This is a plausible explanation for why President Obama might rightly want to propose a deal that seeks a huge amount like $1.6T in new tax revenue, or why Republicans would suggest such Draconian cuts to government spending on entitlement programs. Both are hoping that any future offers look enticing by comparison, but if the initial offers are framed as ultimatums, there might not be any counter offers to consider. Since we have already seen how most people react to insulting offers, this could inhibit compromise and lead us straight over the fiscal cliff, a result that is paradoxically appealing to both parties yet benefits no one.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.