The prisoner's dilemma and the financial crisis
Imagine that you and another armed man have been arrested and charged with jointly carrying out a robbery. The two of you are being held and questioned separately, with no means of communicating. You know that, if you both confess, each of you will get ten years in jail, whereas if you both deny the crime you will be charged only with the lesser offense of gun possession, which carries a sentence of just three years in jail. The best scenario for you is if you confess and your partner doesn’t: you’ll be rewarded for your betrayal by being released, and he’ll get a sentence of fifteen years. The worst scenario, accordingly, is if you keep quiet and he confesses.
What should you do? The optimal joint result would require the two of you to keep quiet, so that you both got a light sentence, amounting to a combined six years of jail time. Any other strategy means more collective jail time. But you know that you’re risking the maximum penalty if you keep quiet, because your partner could seize a chance for freedom and betray you. And you know that your partner is bound to be making the same calculation. Hence, the rational strategy, for both of you, is to confess, and serve ten years in jail. In the language of game theory, confessing is a “dominant strategy,” even though it leads to a disastrous outcome.
In a situation like this, what I do affects your welfare; what you do affects mine. The same applies in business. When General Motors cuts its prices or offers interest-free loans, Ford and Chrysler come under pressure to match GM’s deals, even if their finances are already stretched. If Merrill Lynch sets up a hedge fund to invest in collateralized debt obligations, or some other shiny new kind of security, Morgan Stanley will feel obliged to launch a similar fund to keep its wealthy clients from defecting. A hedge fund that eschews an overinflated sector can trail its rivals, and lose its major clients. So you can go bust by avoiding a bubble. As Charles Prince and others discovered, there’s no good way out of this dilemma. Attempts to act responsibly and achieve a cooperative solution cannot be sustained, because they leave you vulnerable to exploitation by others. If Citigroup had sat out the credit boom while its rivals made huge profits, Prince would probably have been out of a job earlier. The same goes for individual traders at Wall Street firms. If a trader has one bad quarter, perhaps because he refused to participate in a bubble, the results can be career-threatening.
Thomas Frank calls this a "smart-for-one, dumb-for-all" problem. What's rational for the individual is fatal for the collective. It's why we'll never get rid of bubbles. They don't rely on people being stupid, or even evil. They just rely on irrational profit streams that are then tapped by rational imitators. This is why the most important aspect of financial regulation is crude, strong limits on leverage so no single bank can owe enough money that the system relies on its health. We can't protect against the occasional fire. But we can protect against it consuming everything in the neighborhood.
October 29, 2009; 11:04 AM ET
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