By Gautam Samel

“Crisis” is a buzzword used often in the world of money and finance. Catastrophe, cataclysm, disaster, and “black swan” events are some more literary words one might use to refer to a financial crisis, or one might use more crass, personal language to express their loss.

Throughout history, the world has seen a variety of financial crises and market crashes. Unique crises illicit unique reactions from people to protect their finances. Be it the world of finance, investing, markets, or sports, music, sociology – human behaviour, or more specifically human reactionary behaviour is a key part in all these aspects. How one assesses a situation and reacts to it forms the basis of collective human output in all fields.

It is without a doubt that fields such as capital markets and other financial spheres rely largely on human coordination and even more often than coordination, human competition. This article analyses reactionary behaviour to crash events in the world of finance and markets and tries to understand how accurately we can predict our peer’s behaviour when dealing with money through the use of a concept called “The Prisoner’s Dilemma”. 

Originally proposed by Merrill Flood and Melvin Dresher, and later formalized by Albert William Tucker, the “Prisoner’s Dilemma” is one of the key components of game theory. The dilemma looks at the conflict between the individual and the collective and is thus one of the most philosophical and humane aspects of game theory. 

A simple exercise explains this: Imagine two robbers arrested for a bank robbery. They are interrogated separately, and only their confession can get a conviction. If one confesses, the confessor goes free, while the one who didn’t is sentenced to 3 years. If both confess, they are sentenced to 1 year each. If neither confesses, they are let go, since a conviction would not be possible. 

The best course of action for both to take would be to seal their mouths shut and not confess. However, there would always be an internal conflict – “What if the other confesses?” If one behaves selfishly to minimize their own sentence, then the collective result is the worst result in this scenario.

This “internal conflict” is time immemorial and is largely based on trust and human qualities of selfishness and loyalty. Delayed gratification also plays a part – can you set aside current smaller benefits for larger benefits later? 

Stock market crashes and financial crises are often the effects of the Prisoner’s Dilemma where there is a rapid loss of trust in the market and by extension in the economy by the participants. The largest being the risk-averse retail investors and common consumers in the economy, whose decision making affects the collective “trust” in the economy and the market. 

The Great Depression which lasted from 1929 to 1939 is a key display of this phenomenon in the stock market and socio-economic terms. While the dilemma does maintain a strong measure of neutrality between the various schools of economics, it does take support from Keynesian theories to explain human behaviour in times of crisis.

Loss of trust is critical – intense loss of trust in the overall market. People presume the market to be institutions and exchanges – but the market is a massive collective – and the majority of it is formed by the common man and their common (or not so common) interests.

When a retail investor starts losing trust in others like him, he essentially becomes entrapped in the Prisoner’s Dilemma by becoming bearish on the market. Here, the investors sell off to minimize their personal risk – but the collective output is lowered because everyone collectively reacts in the same way – by becoming bearish, just like how Keynes suggests that investment is highly based on expectations.

If collective expectations fail and collective output fails, the markets crash due to powerful selling. Aggregate demand is affected through a cycle by expectations, and if the beginning of the cycle itself is pessimistic, the end is bound to be the same. Reactionary crises like these hurt everyone even when the aim of each and every person was to minimize their own risk. 

The Great Depression also caused widespread unemployment, but one might ask is this a result of the Prisoner’s Dilemma as well? Firms lay off workers due to pessimistic expectations, this behaviour is noted and reflected by the collective market, which means more layoffs, leading to lower output, lower income for the common workers, lower demand, pessimistic expectations once again, and the cycle repeats.

At the heart of the matter is pessimistic expectations that are borrowed from other firms and other investors (individual reaction to collective behaviour) and resembles a schoolchild copying wrong answers from their classmate’s answer script. This demonstrates how the Prisoner’s Dilemma is responsible for more phenomena than just stock market crashes and extends to issues such as rising unemployment as well. 

A sister crisis of the Great Depression is the modern 2008 crisis that took place in the United States and undoubtedly affected the entire world.

The mortgage crisis reflected a similar phenomenon of debts and defaults in the financial world, and thus an eventual crash presented itself. A housing bubble pushed people into buying more and more houses on loans and mortgages, and as the bubble burst, people found themselves paying more on mortgages and EMIs much, much more than what their houses were worth in the market.

As a result, people began defaulting on their housing debt, again a behaviour triggered by a small domino effect of initial defaulting on loans. The prisoner’s dilemma reflects here in the sense of defaults – if everyone begins to default, a crisis is inevitable, however, if people decide to stay strong even if others default, it might lead to a better collective payoff for the sake of temporary personal loss.

However, for most, that is too big a risk to take, as one is essentially advocating holding onto an asset that is rapidly losing value. It could form, however, the best course of action, but the uncertainty is the real player of this game. 

The explanation of this uncertainty and the advocacy of self-serving behaviour at the cost of the collective benefit can be noticed through a brief glance at the Japanese stock index.

After reaching its peak in late 1989, the Nikkei 225 index crashed massively in the coming years, only showing some respite in 2018. From 1990 to 2012, the index kept going strong in a severe downtrend, and one might be aghast to hear contrary to the vast majority of indices across the globe, the Nikkei has not resurfaced to its erstwhile glory yet. It means long term investors in the index constituents (or the Japanese markets are large), those who invested pre-crash, are still holding assets priced lower than their buying price for 33 long years.

Looking at this, how can one possibly justify delayed gratification through collective good, over momentary pleasure through selfishness? 

However, as true as the Prisoner’s Dilemma is, equally true is the truth of the business cycles. While the Prisoner’s Dilemma’s victimization hurts people because of their own individualism-oriented behaviour, it also opens up multiple new opportunities and avenues for those smart and bold enough to take up the risk and place their trust in the market once again.

One final phenomenon to demonstrate this would be the fresh and recent COVID crash of 2020, wherein global indices crashed more than 50% in a matter of a month. Albeit, since then, major indices such as the S&P 500 (USA) and the Nifty 50 (India) have returned upwards of 100% from their troughs in 2020 to their recent peaks in late 2021.

Taking advantage of these cycles through the insights provided by the Prisoner’s Dilemma shows us how even we, the retail investors, who usually lose the most in these crashes and crises, even though we did show it is due to their own self-indulgent behaviour, maximize our own benefit through this dilemma!

This comes as a totally ironic statement since even when we try to trust the market and aim for the collective good, the end goal remains selfishness. 

So, is the collective good the goal and selfishness the means? Is the collective good the means and personal gain the end? This is the real conflict of the dilemma.

When one looks at the Prisoner’s Dilemma, however, one must understand its good repercussions end in business cycles of stock markets, since we demonstrated that it is also responsible for economic issues such as rising unemployment, heavy uncertainty, and factors like these eventually end up leading to political instability. 

The Prisoner’s Dilemma is capable of stirring up all sorts of socio-economic evil that degrades society and ethics. Take bribery or corruption for example. Suppose a police officer holds you up for a petty traffic rules violation – and asks for a fine worth 5000 INR. You instead try to bribe the policeman, paying him a relatively smaller amount of 1000 INR instead, but in this case, the policeman personally benefits.

You personally benefit as well, since compared to the government mandated 5000 INR fine for your violation, you can get away with a relative slap on the wrist. However, here one sacrifices the collective good as one does away with all the values and ethics of a civilized society in exchange for personal gain.

We must ask ourselves the critical questions again. What exactly are the means and what is the end? Collective good? Or personal gain? Only when we answer these questions truthfully, will we be able to use this double edged sword with desirable results.

Gautam is a columnist at CNES and student at Jindal Global University.

Image credits – University of Michigan