Thought Experiment – A Macro-Game of Bankers and Households

Today is going to be a creative post, that is a thought experiment, and anyone who is familiar with Game Theory will recognise the Prisoner’s Dilemma underlying my game. I was inspired by Schelling’s Micromotives and Macrobehavior to think a little bit more about the group dynamics and interactions within the economy. Especially in Macroeconomics we tend to assume that economic actors have certain preferences and, given these preferences, make optimal decisions to maximise their utility. Yet this might hold for “free market activities” which do not have a social dimension, but normally we would expect to see contingent behaviour; that is behaviour “that depends on what others are doing” (Schelling, 1978, p.17).

Let’s assume that our fictitious economy consists of only banks and households. We also have an impartial government as regulator on the side. Both banks and households have two choices; they can either play it safe or play it risky. In particular, banks can decide to sell safe products or risky products. Likewise, households can play it safe by not taking on excessive debt, or they can play it risky and invest in risky assets or take out large mortgages for their dream house. In sum, we have two players and two choices in our economy. To maximise their payoffs (think profit, income or wealth) both households and banks want to play it risky. In particular, the bar underneath the payoff “3” indicates that “play risky” is the dominant strategy for each player.

banks and consumers.png

Having set up our game, let’s start with an economy just after a recession. Government tightened financial regulation over the downturn which prevents banks from selling risky products and provides households with proper incentives to pay down their debt and not take out risky loans. So we are in the upper left corner of our game matrix. Banks and households must play it safe, because “play risky” is not a feasible option. This is indicated by the dotted red line. One might call this “social organisation” as legitimate government intervention or, if favouring a free market without any government action, dictatorship. However, in our game the government with its role as regulator stabilizes the unstable equilibrium.

For a while our economy works pretty well. Consumers pay down their debts and are happy to play it safe. Banks are happy to provide their customers with safe products. But over time vivid memories of the past recession fade and government regulation feels too tight, given that our economy is doing well. Having paid down their debt, consumers feel prepared to build their dream house. Their aspirations for wealth and status rise. Banks return to business as usual and seek to maximise their profits. They start lobbying government to deregulate financial markets and they will eventually succeed. Likewise, consumers will start to advocate a removal of the strait jacket and government will have to listen. As the barriers for households and banks fall, so does the “social organisation”. Our equilibrium in the upper left corner becomes unstable. Both consumers and banks now have the incentive to play it risky. They will end up in the bottom right corner of our game matrix eventually.

Households and banks can play it risky for some time, meaning that the negative payoffs compared to the coordination on “play safe” in the upper left corner might not be obvious right away. This is because risky choices do spur economic growth, entrepreneurial activity and innovation. Yet they probably also trigger a speculative bubble, including excessive debt and risk-taking, in our economy.

Left to their own devices, households and banks continue to play it risky. But at some point the bubble bursts due to rising financial instability and euphoria turns into fear. Households and banks call for the government to step in. On the one hand, banks probably need financial support. On the other hand, consumers want more protection and might need financial support as well. The government agrees to step in conditional on tightening financial regulation. In sum, we are back in the upper left corner of our game matrix with a renewed “social organisation” enforced by government and a stable play-it-safe equilibrium.

The goal of my hypothetical game is not to model a real-world economy but to illustrate the social dynamics underlying macroeconomic outcomes. While the game might not be perfect, it is intended as a nudge to get the bigger picture of contingent behaviour. The game exemplifies the coordination failure together of the two groups without an impartial third party with whom they can contract for social organisation. Both banks and households would be better off playing it safe all the time. Yet, in my game we are going to see cyclical behavior. The drive to maximise profits and increasing aspirations for wealth and status will always induce banks and consumers to advocate for less regulation over time.

Many thanks for staying with me until the end of my thought experiment!

Jasmin


References

Schelling, T.C. (1978). Micromotives and Macrobehavior. New York: W.W. Norton & Company.

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