Game Theory, Evolutionary Biology and the Financial Meltdown

Bob Frank (who was my teacher, boss and neighbor in grad school and whom I admire immensely) puts an interesting spin on the credit market meltdown. It is actually a narrative that I have told often using game theory as a setting: no one financial institution could be the one to not engage in the risky behaviors without potentially jeopardizing its survival even though they might have known that by doing so it was jeopardizing its survival. But if all agreed to do so together they woudl all be better off (and so would we). It is a classic prisoner's dilemma.

Frank puts this same narrative in evolutionary biology terms, but we know that evolutionary biology and game theory are very closely linked so it makes sense. But Bob is a master at telling a compelling story...

Though Adam Smith is ­almost universally regarded as the father of modern economics, most economists will eventually see Charles Darwin's ideas as the true intellectual foundation of our discipline. Smith's modern disciples celebrate his invisible hand theory, which says markets harness individual self-­interest to serve society's interests. Smith himself was more circumspect, claiming only that self-interested actions often lead to socially benign outcomes. But that claim is remarkable enough. Competition among greedy producers often yields innovations that result in cheaper and better products for everyone.

It was Darwin, however, who better grasped the complex relationship between individual and social interest. And we must turn to his account if we are to understand the recent meltdown in financial markets. His deep insight was that natural selection favours traits and behaviours according to their effect on individual organisms, not groups. Sometimes individual and group interests coincide. But interests at the two levels often conflict.

Male body mass is a case in point. Most vertebrate species are polygynous, meaning that males take more than one mate if they can. The qualifier is important, because when some take multiple mates, others get none. The latter don't pass their genes along, making them the ultimate losers in Darwinian terms. So it is no surprise that males often battle furiously for access to mates. Size matters in those battles. And hence the evolutionary arms races that produce larger males.

Bull elephant seals often weigh more than five times as much as females. But their size is a handicap, making them far more vulnerable to sharks and other predators. Given an opportunity to vote on a proposal to reduce their weight by half, bulls would have every reason to favour it. But they have no such opportunity. And any bull that weighed much less than others would never find a mate.

Similar conflicts arise when individual rewards depend on relative performance. This payoff structure, common in financial markets, helps explain why those markets sometimes fail catas­trophically. Wealth managers' salaries depend primarily on how well their investments perform in relative terms. Funds offering higher returns immediately attract cash from rival funds. If the invisible hand functioned as Alan Greenspan and other modern disciples of Adam Smith imagined, there would be no problem. Investors would be fully compensated for any additional risk they took in search of higher returns. But human brains forged by natural selection don't work as assumed in economics textbooks.

As our brains were evolving, immediate threats to survival loomed everywhere. Natural selection thus favoured a nervous system keenly sensitive to immediate relative payoffs, much less so to distant ones. Anyone disinclined to seize immediate gains at the risk of having to incur costs in the future would experience low relative rewards in the short run. And when competition was intense and immediate, such individuals often didn't survive to see the long run.

In market settings, a nervous system biased in favour of short-term relative reward is a recipe for disaster. When the price of an asset like housing is rising steadily, unregulated wealth managers can create leveraged investments that generate enormous rates of return. Even in the early years of this decade, many experienced analysts were warning that several mortgage-backed securities were poised to tumble. But investors faced a tough choice: they could earn high returns by continuing to invest in them, or they could move their money elsewhere. Many rejected the latter strategy because it would have required watching friends and neighbours pass them by.

Wealth managers felt compelled to offer the risky investments, since many customers would otherwise desert them. Managers also knew there would be safety in numbers when things soured, since almost everyone had been following the same strategy. The resulting collapse was inevitable.

Adam Smith's invisible hand is a truly extraordinary insight. But when rewards depend on relative performance, it doesn't always deliver.

The financial meltdown that caught Adam Smith's disciples off guard would not have surprised Darwin. One of his central themes was that because much of life is graded on the curve, wasteful arms races create conflict between individual and social interests. The good news is that unlike other animal species, humans can often resolve such conflicts through intelligent regulation.

Here is Bob on carbon offsets as well.