Banking Crises - Part 2.

Free banking, a view supported by Hayek among others, was for a long time seen as the progressive way forward in Western finance. By the early 2000’s it was popular amongst not only bankers but also politicians and academics. This can be illustrated in a quote from Gordon Brown in a speech he delivered to the CBI (Confederation of British Industry) in 2005 where he described his view on regulation as “not just a light touch, but a limited touch”.

So we can only assume that free bankers would have been in full support of the laissez faire system that second life’s banks were operating in. However, as described in the previous post, the financial system turned out to be anything other than stable. Following the collapse of Ginko bank many of the games other banks took losses on investments, particularly in real estate, that they had made. Following the losses, the banks struggled to meet the high rates of interest they had promised and second life experienced another round of bank runs.

According to the free banking view this should have resulted in the transfer of deposits from weak banks to strong banks. While the system was struggling some banks, like SL Bank, were comfortably earning enough to pay depositors interest, and so should have received the transferred deposits. However, depositors couldn't distinguish the strong from the weak and all the banks suffered from the lack of confidence. There was a problem of contagion.

Second Life, famously free from rules was forced to accept very strict regulation on the banking industry. Linden Labs banned all institutions from offering interest on deposits unless they could produce a banking charter that is applicable in the real world. At this stage no banks have applied. Although it is always tempting to believe that the market will regulate itself there is little evidence that they do and in an industry like banking, it is not worth the risk to find out.

Linden Lab's announcement can be found here:
http://tinyurl.com/LindenLab

Banking Crises - Part 1.

2007 saw the beginning of a financial crisis that was far larger than anything experienced since 1929. The freezing of credit in the inter-bank market and the general lack of action by banks, in terms of loans and investment, had a massive impact on both the financial sector and the wider economy. The relatively upbeat mood in Davos this year hints that we are moving out of the battle of the financial crisis into the long war of economic recovery. Banking crises are, however, not only present in the real economy, but also in virtual economies too.

Second Life players are easily offended when the online experience is referred to as a game, they treat it as a virtual environment. The view taken by Linden Labs, the games creator, is that they provide the software and the hosting servers and the players create the world. In this way the rules Linden Labs lay out are very sparse and the economy operates under a laissez faire approach.

This however has been found to have some undesirable effects, namely, bank runs. The first one occurred with an in-game bank known as Ginko. Suspicion should have been high that the bank was a high-risk entity as it promised 40% returns on deposits per annum. Ginko invested heavily in Second Life casinos, this proved disastrous as Linden Labs banned any and all gambling activities. With no deposit insurance scheme and sequential service being in effect depositors rationally acted following the large losses and withdrew their deposits. Within days Ginko had collapsed with the cost to players estimated at being $750,000.

This event illustrates depositor reaction to a single banks misfortunes, later in the week I’ll take a look at the systematic crisis that soon followed.

A New Perspective

Economists are deeply divided on many subjects, a point illustrated in San Diego on Jan. 5^th this year at the American Economic Association where the only unanimous decision from the 50 panel economists was a rejection of returning to the gold standard. One thing that economists can (mostly) agree on is the strong prevalence of bubbles, financial panic and crises that have been present during the last few centuries.

Bubbles have been recorded throughout history in commodities (tulips 1630’s), equities (Wall Street 1929) and property (2005) to name a few examples. Financial panics, as evidenced by the graph below, have unfortunately proven to be the rule rather than the exception since modern banks first appeared in Renaissance Italy in the 14^th century. This blog agrees with authors such as Dodd (2002) and his argument that banks exert too many externalities to be left unregulated.

The main question then is how best to regulate? A problem of economics compared to natural sciences is the extreme difficulty that comes with setting up experiments and tests since so many uncontrollable factors influence outcomes like bank stability, GDP, unemployment etc. This makes it difficult to test which kinds of regulation will have the desired impact without playing with the real economy. That’s where this blog hopes to offer some contribution; through exploring the opportunities virtual economies found in online games can give to economic and financial experimentation.

We already have the start of collaboration of economics within virtual economies. The most well known comes with CCP, the Icelandic company which owns Eve Online, and Eyjolfur Guomundsson the economist who leads a team of eight analysts for the company. In a complicated game with over 400,000 players, larger than the population of Iceland, economic management is essential to keep the economy functioning. Others, like Greek economist Yanis Varoufakis, have joined gaming company Valve in an attempt not just to manage in-game economies but test them.

Over the coming weeks this blog will highlight the similar experiences shared by virtual and real economies with financial crises and bubbles. It will also attempt to highlight areas where virtual economies can help expand our understanding of the real economy.