Prisoners Dilemma

Posted by Morgan on 10th Jun 2008

 

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I always wondered if my university lectures on game theory and their practical use in every day business would be relevant and finally they seem to be….

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What is he on about I hear you ask? The prisoner’s dilemma is based on the concept that individuals will always act selfishly to protect themselves even if a cooperative (collective) solution would be mutually beneficial to all.

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See: http://en.wikipedia.org/wiki/Prisoner's_dilemma

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The UK property business is currently griped by a liquidity crisis, not a credit crisis as is generally reported. The liquidity crisis stems from the facts that the banking industry has on mass turned off the supply of money to property investors whether they are large or small, capable or incapable. This inability to borrow is having the effect of starving the market of capital and given that property is possibly the most capital intensive business in the world it has lead to a state of paralysis.

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You can not buy, so you can not sell. There are no comparable trades so you can no longer accurately value a property. The spiral goes on…

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Under such circumstances it is perfectly logical that a bank should choose to avoid lending money to a property investor. If markets fall then the bank may well lose money, this is a big risk when the bank is already carrying a major exposure to the sector through its existing loan book.

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However, if every bank takes this logical individual decision to withdraw from the market, at least temporarily (most of them have already done this) the individually logical action becomes a collective illogical (not to say disastrous) decision.

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Through withdrawing liquidity and the availability of capital entirely the banks would create a vicious downward cycle whereby capital values are forced to fall until cash buyers can establish a clearing price. This would create enormous value destruction and the banks would collectively and individually lose more money through losses associated to their existing lending book than they stood to lose had they continued to lend and written the occasional bad loan.

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What is required today is for the big banks to show leadership and to make collective policy decisions. If this does not happen then the liquidity crisis is likely to mutate rapidly into a credit crisis as property values fall and the banks experience major losses.

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Game theory has been around since the 1950’s, it was often used to model super power relations, maybe banking leaders should start to work collectively before the situation goes nuclear?

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