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The financial crisis: a humble evolutionary economist’s perspective
By carstenherrmannpillath | September 17, 2008
The financial crisis is deepening, and no end is in sight. Yesterday John Hartley visited me at Frankfurt, and during our inspiring conversations, an evolutionary economics and cultural science approach came up in my mind, which might offer a precise explanation which differs somewhat from the mainstream view. In a nutshell, the argument is as follows.
- The root of the crisis lies in the US mortgage business, as is well known. In particular, the instrument of interest-only or payment-option adjustable rate mortgage proved to be fatal, as they lead toward a rapid increase of indebtedness while housing prices fall. Why did the people conclude this kind of contract? The EE explanantion is straightforward and refers to the theory of hyperbolic time preferences which was crafted by psychologist Ainslie and went mainstream with the work of David Laibson, including neuroeconomic validation recently. This means: People discount the far away future much steeper than the close present, such that they often fall prey to the seduction of present oportunities, and do not properly weigh future costs. Thus, a shift of financial burdens resulting from mortages will lead towards an “irrational” expansion of demand.
- The question is, why did lenders take the risk? If they also share hyperbolic time preferences, the same argument applies. However, most economists would argue that institutions and organizational routines support the emergence of rational benchmarks in behavior (after all, we all use a wake-up call to fight the seductions of longer sleep in the early morning). So, lenders should act rationally. This is an interesting point, because the rational expectations issue enters. If they are rational, they should know the hyperbolic time preferences of their clients. So they would have avoided the risk. The only argument would be that they had sufficient information to assume that housing prices would rise continuously, thus enabling their clients to pay back. But this leads into a contradiction, because given the hyperbolic time preferences, rational expectations would have precisely forecasted that there would be a sudden increase of housing sales by illiquid owners, thus resulting in a decline of prices. Thus, lenders would have acted irrationally by introducing the mortgage schemes.
- The other possible explanation is that lenders faced a Prisoners’ dilemma, acting rationally. This means, they would have an incentive to free ride on other lenders’ behavior, if they avoid the risk. Then, offering the new mortgage scheme would lead to higher profits for the free-rider. In the end, all lenders offer the schemes, which is a Pareto-inferior Nash equilibrium. This is the classical justification for government regulation on financial innovations. However, this explanation is overly stylized and would only serve the goal to maintain the rationality assumption. Here cultural science comes into play.
- As is well-known from evolutionary game theoretic analyses of the PD games, local interaction with correlated equilibria can maintain cooperation, as in multi-agent modelling. In our example: Just imagine clubs of lenders who interact frequently and would exchange information about the new mortgage schemes. They would possibly converge on a behavioral pattern that would block the transition to the new schemes. So, the major explanation results to be that the network structure of banking has changed in the recent decades. In particular, banking has become more standardized and automaticized, with less personal contacts and local networking. This implies that innovations will diffuse rapidly, possibly in scale-free networks.
- This impact of changing network structures might also explain the second proximate cause of the crisis, the role of mortgage-backed securities. In this case, the evolutionary economics perspective relates with the “market making” approach in recent financial sociology, such as the contributions by MacKenzie. The simple point is that mathematical methods of risk transformation have been diffusing widely, which, however, might stay in an implicit contradiction with the observations in point one, because typically, those models presuppose rational agents.
- The conclusion is that the interaction of hyperbolic time preferences and changing network structures in banking led towards a ’systemic misperception’ of risks, which is almost impossible to correct by the individual bank.
Topics: Uncategorized | 5 Comments »
September 29th, 2008 at 9:35 pm
When I read the conclusion in the last paragraph I find it seems like market failure which also needs the interference of government. I also feel the description about the lenders and debtors sounds like Information asymmetry which was crafted by Kenneth J.Arrow, but not completely same. I don’t think that Prisoners’ dilemma can explain this event because not every bank makes the same choice; Golden State avoided the first shock of Sub-prime mortgage loan crisis successfully.
September 29th, 2008 at 9:37 pm
Not Golden State,Goldman Sachs is right.
September 30th, 2008 at 3:47 pm
[...] Another economist, Carsten Hermann Pillath, offers up an approach based on evolutionary economics and cultural science, bringing up game theory and the prisoners’ dilemma (see The financial crisis: a humble evolutionary economist’s perspective). [...]
September 30th, 2008 at 3:49 pm
[...] Another economist, Carsten Hermann Pillath, offers up an approach based on evolutionary economics and cultural science, bringing up game theory and the prisoners’ dilemma (see The financial crisis: a humble evolutionary economist’s perspective). [...]
October 1st, 2008 at 7:39 pm
This is the sort of thing that happens when folks try to reason out phenomena based on “slices” of a much more complex reality. Everyone’s take is as if his or her view was the only thing that mattered. A bit like the blind mind of Hindustan
who ended up making fools of themselves by insisting that everything must have an underlying cause and effect.
So greed was the cause, until one finds out that it is not enough, he has to ask whose greed? Then wait, greed is what partly made the system itself exist, so then one moves on to capitalism. Again, dishonest, if only because there is also no alternative. So it goes on and one, until one finds out that there really is no one “complete” explanation. What fools folks make of themselves through mental self deception.
Because, in fact there is none, this is systems dynamics at its best – there is no clear start or end. None of the parts relate to each other or even to the whole. But again, folks will not buy that because it is so ego deflating but especially disappointing for those who must blame everything on their peeves – Bush, capitalism, the US, the world.
So all this handwringing is all pointless self inflation. Just take it as part of the ultimate boundary of understanding.