Karl Smith Understands That Bubbles Are a Sort of Prisoner's Dilemma

Here:

"If a lender tries to play it safe then she will still get screwed by the fact that any loan she makes will be to a buyer who is paying market price, which is bubble inflated. Yet, she will be doubly screwed by the fact that she is losing market share and thus not even making a lot of money on the upside of the bubble.

"So she is pushed to lower standards as well.

"This is amplified by the fact that the actual consequences she faces as a decision maker will be harsher the more atypical her choices are. If she goes with the flow she probably will not be punished when everything goes bad. If she refuses to go along with the flow then she will be punished for making low returns while everyone else is profiting from the bubble."

10 comments:

  1. Exactly! I've explained it to people in the same way.

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  2. While perhaps there will be psychological effects that may make .managers at loan companies likely to "go with the flow" and accommodate bubbles I do not see how this makes sense from a business perspective.

    A lender maximizes profits by accurately assessing risk and pricing loans accordingly. Lowering lending standards to gain market share would lead to more defaults and lower average profits.

    If others are lending below cost to take market share - then surely its best to leave the market for a while than try and compete with them and make losses.

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    1. rob, I researched this extensively for my 2003 paper with Roger Garrison: Smith is absolutely correct here. Managers do not care about "maximizing profits": they care about maximizing their salaries. When everyone else is making big money lending wildly (not "below cost"!) they have to do so too or they are out of a job. When everyone goes bust, they can just shrug and say "Happened to everyone!"

      The top 1% did very well from the Great Recession.

      Also see Carilli and Dempster on ABCT as a prisoner's dilemma.

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    2. I can how that would work from a psychological perspective but I still don't get the game theory aspect. I still think that bankers that follow sound business principals will outperform those that follow bubbles (at least if you take moral-hazard out of the picture) in the long-term.

      Let me think it through some more.

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    3. In an ABCT context then lower interest rates and increased lending are driven not by irrational behavior but by a real increase in the money supply.

      Both lenders and borrowers are simply making good business decisions in reaction to the increased money supply. Where things go wrong is when borrowers make business decisions based on the assumption that the short-term effects of the increased money will persists into the long-term.

      Banks that saw the implication of ABCT could adjust their lending and avoid losses when borrowers start to default.

      Borrowers who took advantage of lower interest rates but understood that they should not expand too much in "bubble" lines of production will make better profits over the business cycle.

      Psychological factors may cause people to make bad decisions but I'm still not getting why this a "prisoners dilemma" .

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    4. Did you go read Carilli and Dempstrer? Or would you prefer I type their paper into a com box here?

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    5. Oh, you expected me to actually do some research before responding !

      I looked at that paper (BTW: the URL is here

      http://www.gmu.edu/depts/rae/archives/VOL14_4_2001/4_carilli&dempster.pdf)


      They assume that banks are faced not with an increased money supply but increase demand for loans to which they can respond by either increasing interest rates or lowering reserve ratios.

      Their claim that banks will choose to reduce reserves and increase lending is dependent upon their claim that

      "With a monopoly currency, however, part of the cost of lending can be passed
      on to the rest of the banks. This happens because the original loan becomes only a small
      part of the monopoly money supply".


      1. I'm not sure I get why this is true. If a bank increases lending and all other banks don't then it will likely face a drain on reserves that will cause it to have increased costs to cover. This would make increased lending NOT the optimal decision unless it knows all other banks will react in the same way.

      2. Even it is true then this means that monopoly currency has introduced moral hazard and if removed the alleged prisoners dilemma goes away.

      If does appear that if all banks acted in unison and all lowered reserve requirements then they may all benefit. I don't think this is a prisoner's dilemma though but just a feature of banking that may (or may not) be solved by either regulation or free market activity.


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  3. Posted this earlier but suspect it may have got lost:

    "Oh, you expected me to actually do some research before responding !

    I looked at that paper (BTW: the URL is here

    http://www.gmu.edu/depts/rae/archives/VOL14_4_2001/4_carilli&dempster.pdf)


    They assume that banks are faced not with an increased money supply but increase demand for loans to which they can respond by either increasing interest rates or lowering reserve ratios.

    Their claim that banks will choose to reduce reserves and increase lending is dependent upon their claim that

    "With a monopoly currency, however, part of the cost of lending can be passed
    on to the rest of the banks. This happens because the original loan becomes only a small
    part of the monopoly money supply".


    1. I'm not sure I get why this is true. If a bank increases lending and all other banks don't then it will likely face a drain on reserves that will cause it to have increased costs to cover. This would make increased lending NOT the optimal decision unless it knows all other banks will react in the same way.

    2. Even it is true then this means that monopoly currency has introduced moral hazard and if removed the alleged prisoners dilemma goes away.

    If does appear that if all banks acted in unison and all lowered reserve requirements then they may all benefit. I don't think this is a prisoner's dilemma though but just a feature of banking that may (or may not) be solved by either regulation or free market activity."

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    1. "I'm not sure I get why this is true. If a bank increases lending and all other banks don't then it will likely face a drain on reserves that will cause it to have increased costs to cover."

      Except the loan is sold right away.

      But here is the big thing: you are treating the system as if companies are run for the benefit of the owners. That is certainly not the case: they are run for the benefit of the managers.

      If I can make three years of $20 million in bonus selling shite loans to rubes in flyover country, what do I care if the whole thing blows sky high in year four? I've already bought my mansion in the Hamptons!

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    2. "Except the loan is sold right away."

      If a bank is the only one not to raise rates won't it have problems selling it on.and may take a loss?


      "But here is the big thing: you are treating the system as if companies are run for the benefit of the owners. That is certainly not the case: they are run for the benefit of the managers."

      I also suspect this may be the case. . But that is not what is assumed in that paper where banks and firms act in a profit-maximizing manner

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