Congress is lining up the list of suspects to assign blame for the financial crisis. However, all of the obvious suspects — the Fed, Fannie and Freddie, mortgage companies, banks and borrowers — have been players in the mortgage market game for years. Why is there a crisis now? Perhaps it was because they were playing by a new set of rules.
To make sense of real world events, economists commonly study the interactions between people or groups through the lens of game theory. Many may be familiar with game theory from the movie “A Beautiful Mind,” which was about the life of John Nash, a mathematician who won the Economics Nobel in 1994 for pioneering the field. More specifically, Nash developed one particularly useful strategy for how people interact, or play games in the real world. He said everyone will use a strategy they believe will lead to the best outcome for them given their best estimates on what everyone else is going to do as well. Like Nash’s theory, much of game theory is focused on trying to predict or explain strategies that different participants in an economy will play, given their individual incentives. And these incentives can depend on a whole variety of things, such as available technology, individual preferences (e.g. attitudes about taking on risk), and even public policies developed to encourage or discourage certain tendencies.
What does all this have to do with the current financial crisis? The crisis can be viewed as an outcome of many players choosing strategies given the game. What was that game? The game was based on the goals laid out in the Community Reinvestment Act (CRA) legislation. For a little over a decade, the legislation was relatively broad. However, beginning in 1992 the government began seeking ways to more definitively implement the CRA. Through the U.S. Department of Housing and Urban Development (HUD), the government designed less flexible rules that set mandated targets for home ownership. These rules specified minimum percentages of special affordable loans that Fannie Mae and Freddie Mac had to buy. The special affordable loans are mortgages designed for “subprime” borrowers. This created additional demand for these loans in need of supply. Banks and mortgage companies stepped in to “meet the need.”
Another branch of economics that uses game theory to study questions regarding the execution of policy goals is mechanism design, which three economists won the Nobel Prize for last year. One of the notable developments of mechanism design has been to show just how tricky it is to design and then implement effective policy goals. In fact, some have suggested that given the chaotic nature of the environments that policies affect, successful implementation of specific goals may be impossible. (Theorems have been proved about this.) Instead the rules (or the mechanism) often leads to undesirable outcomes, particularly when it is impossible to predict all the possible future states of the world; in this case, states like home price appreciation, proliferation of multiple layers of securitization, computer-aided risk modeling technology, Fed interest rate policy, etc.
The CRA did not cause the crisis. Instead, the crisis is the result of a combination of the outcomes derived from the strategies of each of the players. Using HUD to implement CRA goals just created the game that gave the players the incentive to choose those strategies.
Paul Winfree contributed to this post.