Some days ago I received an email from a former student of my strategy courses at the Open University of Catalonia www.uoc.edu who asked me some interesting questions:
If the Financial System (and the economic world) has to move from a model based in volume (wasting resources) to a new model based on efficient management of capital and liquidity (critical and scarce resources) driven by a more strict regulation, why the process is taking so long?
What’s the point of pouring millions of Dollars/Euros in financial system rescue packages and not preventing the bad practices which produced the 2008 Financial Crisis from repeating themselves?
He added: You always say that these changes take time, but the question is why?
In my opinion, theory of games, which explains the behavior of rational decision-makers in conflict and cooperation situations, provides a good analytic model to answer to my student’s questions.
One of the highest contributions to this theory was proposed by John Forbes Nash (1994 Nobel Prize of Economics) and it’s named after him “the Nash Equilibrium”.
A typical example of the Games Theory is the Prisoner’s dilemma which proposes the following scenario.
Two prisoners have been detained. And they’re asked to confess.
Four possibilities emerge from the dilemma:
- Prisoner A confesses and prisoner B refuses to confess. In this case they’re both declared guilty but prisoner B receives a much harder penalty (20 years) than prisoner A (5 years).
- Same case if prisoner B confesses and prisoner A refuses to confess.
- Both prisoners confess. They’re both declared guilty (10 years).
- No-one confesses. They’re both released because there’s no other evidence against them.
It seems clear that the best option for them is number 4. But without a mutual agreement they will both confess as it’s the best option which doesn’t rely on the other prisoner.
On the other hand if they make a pact and don’t confess (because they can communicate and trust each other), they both will be in the best situation; this particular case is called “iterated prisoner’s dilemma” which ends with a collaboration equilibrium.
Now, let’s look at the current situation of the Financial System from the Games Theory perspective.
The financial system needs public support for avoiding bankruptcy and the regulator requests the system to abandon risky activities (increase solvency, liquidity, disclosure etc.) for avoiding future crisis (growth rates are going to be low from now on so we cannot afford wasting solvency).
If we describe this situation from the prisoner’s dilemma perspective, we get the following scenario.
- Governments rescue the financial system and the financial system doesn’t eliminate/reduce speculative activities. Bad scenario for the government.
- Governments don’t rescue the financial system and banks don’t eliminate bad practices. Total crash. Very bad scenario for both sides.
- Governments don’t rescue the financial system and banks eliminate bad practices by themselves. Bad scenario for the banks.
- Governments rescue the financial system and the financial system eliminates speculative activities. Collaborative equilibrium.
Of course this is a necessary simplification for writing a short and direct post and the reality is much more complex than this example.
Games theory offers a very useful approach for analyzing many systemic problems, economics, business, biology, politics, etc. I thought it could be interesting to discuss the Financial Crisis from this perspective.
Looking forward to read your opinions.