Len Fisher, Behind the Headlines: Game Theory in the News Blog

Can game theory help us in the current financial mess? According to some skeptics, the answer is no, because they believe that game theory can be manipulated to explain anything. “If a bank president was standing in the street and lighting his pants on fire” says strategic analyst Richard Rumelt “some game theorist would explain it as rational.” I am keenly interested in what game theory has to offer, and Rumelt’s example seems to offer something very practical when it comes to the credit crunch. If the leaders of financial institutions had known that the eventual penalty for offering toxic loans and concealing the true value of their assets would be having to burn their britches behind them, perhaps the crunch could have been avoided.

Ok, maybe I have my tongue in my cheek, but the underlying point is that things might have been different if the CEOs involved had had to pay a high personal penalty for failure in the game that they were playing. As it was, the temptation to press on with their gambling strategies was overwhelming, since they figured that the public, rather than themselves, would pay the penalty if those strategies failed. In the words of Citigroup’s chief executive officer Charles O. Prince, explaining why Citigroup Inc. wasn’t slowing its lending amid the turmoil of the U.S. subprime mortgage market in July 2007: “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Price and others were dancing to the dangerous music of game theory, which in my view does have a lot to offer, both in understanding the causes of the crunch and in offering long-term escape routes.

The crunch itself arose, at least in part, from a situation that game theorists know as The Prisoner’s Dilemma (when it involves two parties) or The Tragedy of the Commons (when many parties are involved). Both names refer to situations where the rewards accrue to individuals, but the costs are shared by the community – in this case, in the form of bail-outs that come from our taxes, not to mention the ruined lives of those who have lost everything.

In such situations, cooperation would lead to the best overall outcome, but individual parties are tempted to break the cooperation because this will benefit them more, no matter what the other party does. The dilemma comes from the fact that, when all parties use the same undeniable logic, they somehow end up in a worse situation than if they had maintained the cooperation in the first place.

Our financial institutions have certainly landed themselves in a pretty bad situation. If they had cooperated by revealing the true extent of their underlying assets to each other early on, trust between them might have been maintained. Loss of this trust was one of the principal causes of the crunch.

In the short term, we can’t do much about it until we have taken the painful steps of isolating the toxic loans and curing the institutional behaviour that led to such loans being made. In the longer term, we face the even more serious issue of rebuilding trust in and between financial institutions. In the latter case, game theory has a great deal to say. In particular, it suggests strategies that make it in the best interests of financial institutions to reveal their assets more openly to each other.

The best of such strategies do not need legislation to drive them, but are self-enforcing. To give one example, if two institutions are linked in such a way that if one falls the other must follow, then transparency and communication between them are become practical necessities.

This is not to say that game theory has all the answers; that would be a ridiculous claim. But it does provide a new context in which to think about our problems, and theoretical strategies that can often be adapted to real-world situations. These strategies belong to everyone, and should no longer be the exclusive province of experts.

If all else fails, we could still get the heads of financial institutions to light their pants on fire. Who knows – it might work. At the least, it would provide some satisfaction to those of us who have suffered the consequences of their decisions.

© This article is copyright Len Fisher. You are welcome to reproduce this article in full or in part, so long as you include the acknowledgment “Written by and copyright to Len Fisher, author of Rock, Paper, Scissors: Game Theory in Everyday Life“.

Share This