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The Credit Crunch as Game Theory

by TRAVIS PANTIN
Fri, 16 Nov 2007
updated Mon, 19 Nov 2007 at 10:16 AM

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A professor at the London School of Economics, Willem Buiter, posts a lengthy treatment of the current credit crisis on his blog, Maverecon (blogs.ft.com/maverecon). His conclusion: "The single best thing that could happen would be for the true magnitude of the losses suffered by banks and other exposed parties to be revealed." Unless that happens, "fear of getting stuck with the hot potato makes banks unnaturally unwilling to extend credit against the kind of collateral that they would not have thought about twice accepting at the beginning of the year."

At Marginal Revolution, Tyler Cowen uses game theory to show why banks might be unwilling to follow Mr. Buiter's advice.

"Think of bank managers as being collectively averse to admitting a loss, if only because they might be blamed for that loss. So at first no one admits losses. Even though the market knows the losses are there, the market just doesn't know exactly where. But then the market has no accurate valuations for some asset classes. Those asset classes can't serve as collateral because just about any result—relative to an unevaluated base—could count as a loss and we've already seen that managers are loss-averse."

Marginal Revolution reader Adam Nelson provides an example: "I think of it a lot like diseases that eventually become symptomatic, given enough time everyone will know, but until then, lots of people don't want to get tested (and aren't publicizing the results of their test). So most information travels on rumor."

Mr. Cowen concludes, "The simple lesson is that bad news can be good news. … Once managers admit their losses, market liquidity can spring back to life and we can avoid a credit crunch. Once managers admit their losses, that is."

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