Today is the day that the Nobel Prize in Economics is presented to the men who laid the foundation of “Game Theory”. The basic idea is that in any complex system individuals behave according to the rules and develop a strategy for winning, or at least achieving their own personal goals. From there, setting up a good economic system is nothing more complex than creating a good board game with a healthy equilibrium.
That’s a very simple way of putting it, but from a policy standpoint it summarizes what’s needed to make any social or economic system operate effectively. One of the big problems we’ve had lately, however, is that the ever so small world presents an ever changing game board – and ever changing rules. The implications for this state of world events are vast and almost unapproachable.
I recently received another installment of the newsletter from John Mauldin. He’s an investment advisor that always has a unique take on things, and is sometimes referred to as a “perma-bear”. I think of him as shrewd, if a bit conservative, and always worth a read. He takes on the current state of “The Game” we call finance in a very interesting way.
This week he quoted an academic paper from Graciela Chichilnisky and Ho-Mou Wu on what they call “Endogenous Uncertainty”. That’s their fancy term for the risks that an individual creates in a game through the actions that they themselves take, whether they know it or not. This comes into large economic systems by the process of hedging or selling derivatives as a kind of insurance against outstanding money that is owed to you – the idea being that if the people you loan it to default, you make up the money from a similar investment that gains from that default.
This is at the heart of how modern capital markets operate. The Black-Scholes-Merton theory is basically that it is possible to completely hedge all of your risk and make a risk-free profit by carefully managing the equilibrium of the market. As long as there are no major disruptions, everything moves along in steady state.
Ah, it’s that one big assumption that’s always done things in. Defaults usually don’t happen one at a time, but as entire industries face slowdowns. Witness the home mortgage market lately, where a hedge against one company by investing in other mortgage products has seen large institutional investments like SIVs meltdown all at once.
That’s where Chichilnisky comes in. Basic game theory – the stuff that won the Nobel Prize – says that successful gamers seek out an equilibrium that is predictable. But new financial instruments enter the market all the time, promising new ways of managing risk. They each set up their own waves of investors and their own networks, all of which are vulnerable to a default by someone along the line. That makes other markets unstable, as they have to cope with defaults in investments made in these new products. For example, the London Interbank Overnight Rate, the money banks in the UK use to keep each other going in the short term, has been hopelessly out of whack since the US home mortgage crisis began. The effects are world wide.
What does this mean, policy-wise? It means that the entire international system is made more vulnerable by every new method of managing risk.
What can we do about this? Chichilnisky puts it this way:
“The other implication of our results is that they help to formalize a ‘multiplier effect’ for policy. In a complex economy, financial policies which succeed in preventing default by one agent also prevent, by a chain reaction, a large number of other defaults at no additional cost. Therefore the benefits have a ‘multiplier effect’. Our results provide support for the policy of requiring reserves to enhance financial stability.”
In other words, the international banking system requires international policy mandating reserves. Who’s gonna do that? Well, that remains to be seen. But what we can say for sure is that the imaginative minds that created all these wonderful new financial instruments have created side-effects that have to be cleaned up by ever larger policy institutes that will, ultimately, have the appearance of making a major power grab not for the interests of stability in the industrialized world, but for the sake of power alone.
Don’t say you weren’t warned. It’s just how “The Game” plays out.