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The prisoner's dilemma and the financial crisis

I'm a bit late on John Cassidy's thoughtful overview of the financial crisis, but it echoes Henry Blodget's take, not to mention my own:

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.

By Ezra Klein  |  October 29, 2009; 11:04 AM ET
 
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Comments

wait a minute didn't certain financial instutions not deal (or deal very lightly) in these risky credit default swaps, etc? Wasn't JP Morgan Chase one of them? If they have a strong brand (as they do) and can maintain their clients they're now seen as the big winners in all of this.

"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"


But GM, Ford and Chrysler can do that now that the taxpayer is footing the bill.
You see what you need to do Ezra is see how it affects the Toyota's of the world (ie the non US government owned automotive companies). I would expect Toyota is being stretched thin by the US government over-extending itself (and the taxpayer)into the automotive market. Now that's what REALLY not fair in the global scheme of things.

Posted by: visionbrkr | October 29, 2009 11:24 AM | Report abuse

This problem is one that's also exacerbated by the rapid low-cost movement of arbitrary amounts of money. Hence proposals for a transaction tax, for vesting rules so that traders and others have to wait to see whether the paper profits they generate are real before using them to buy yachts and houses. Hence the suggestion (still being fought tooth and nail) that people who get paid bonuses based on financial results that are later restated have to send the money back, just as an hourly employee would if someone discovered an error on their time card.

Posted by: paul314 | October 29, 2009 11:26 AM | Report abuse

The close of that message -- "We can't protect against the occasional fire. But we can protect against it consuming everything in the neighborhood." -- is excellent.

Posted by: rmgregory | October 29, 2009 11:40 AM | Report abuse

This is absolutely why strong regulation is needed. A profitable product comes along, and someone or institution will abuse it to make more money, as AIG did with derivatives. Not enough people understand the need to exercise restraint to keep the system going. It is like the tragedy of the commons. This is probably what Greenspan finally saw. Systens that exist to make private profit can't self-regulatie or self-correct for the public good. They need the strong hand of government because there is no limit to the individual greed of many players.

Posted by: Mimikatz | October 29, 2009 11:44 AM | Report abuse

I wonder how the discussion would change if the rules were worked in a way to emphasize collective interests. In other words shift from the single-shot PD to an intereated PD or utilize the Nash Equilibrium.

Posted by: mastersd | October 29, 2009 12:00 PM | Report abuse

Sorry, I thought the Cassidy piece was an excellent example of Tom Friedman disease. Say the perfectly obvious with wide eyes, colorful language and exotic metaphors and everybody goes, "wow, why didn't I think of that?" without actually realizing that they -- and everyone else -- actually did think of that.

The earth is flat? Yeah, there's globalization going on, wowzer.

Ditto here. This stuff is the staple of any undergraduate game theory course. Frankly, it's old hat.

Posted by: wagster | October 29, 2009 12:27 PM | Report abuse

Ezra,

I'm so glad you've read some of the work of the great Cornell economist Robert Frank. He's the field's primary champion of the great importance of positional/context/prestige externalities in economics. More than anyone else I hope he wins the Nobel Prize.

If you haven't read it already, I strongly recommend you read his classic Washington Post op/ed, "Our Climb to Sublime; Hold On. We Don't Need to Go There.", at:

http://www.robert-h-frank.com/PDFs/WP.1.24.99.pdf

He has a whole book on positional/context/prestige externalities, "Luxury Fever". If you haven't read it already, I also strongly recommend it. One of the chapters is, in fact, named, "Smart for One, Dumb for All".

Posted by: RichardHSerlin | October 29, 2009 1:01 PM | Report abuse

Right, isn't this similar to Elinor Ostrom's work with well-governed commons. Here's a good summary from Alex Tabarrok: http://www.marginalrevolution.com/marginalrevolution/2009/10/elinor-ostrom-and-the-wellgoverned-commons.html

"Elinor Ostrom's work culminated in Governing the Commons: The Evolution of Institutions for Collective Actionwhich uses case studies to argue that around the world private associations have often, but not always, managed to avoid the tragedy of the commons and develop efficient uses of resources. (Ostrom summarizes some of her findings from this research here). Using game theory she provided theoretical underpinnings for these findings and using experimental methods she put these theories to the test in the lab.

For Ostrom it's not the tragedy of the commons but the opportunity of the commons. Not only can a commons be well-governed but the rules which help to provide efficiency in resource use are also those that foster community and engagement. A formally government protected forest, for example, will fail to protect if the local users do not regard the rules as legitimate. In Hayekian terms legislation is not the same as law. Ostrom's work is about understanding how the laws of common resource governance evolve and how we may better conserve resources by making legislation that does not conflict with law."

(Also, does WP allow HTML in comments? Never see it. If not, it needs to)

Posted by: zacksherwood | October 29, 2009 1:10 PM | Report abuse

"Thomas Frank calls this a "smart-for-one, dumb-for-all" problem. What's rational for the individual is fatal for the collective."

Kind of like why Medicare can only work for some, and not for everyone in a "robust" public option.

Strange, though, how you can only see the fallacy some of the time...

Posted by: whoisjohngaltcom | October 29, 2009 4:58 PM | Report abuse

There is also an excellent book called "No one makes you shop at Walmart" by Thomas Slee that covers this area, too.

Posted by: williamcross1 | October 29, 2009 8:09 PM | Report abuse

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