a game-theoretic analysis of the economic crisis

http://www.theatlantic.com/doc/200812/blodget-wall-street
"Why Wall Street Always Blows It"
by Henry Blodget
December 2008
The Atlantic

Blodget discusses the causes of the economic crisis. I'm going to pull out three factors which he doesn't really focus on.

"Having already learned the most obvious lesson about bubbles, which is that you don’t want to get out too late, I now discovered something nearly as obvious: you don’t want to get out too early."

"But the future is always uncertain—and amid uncertainty, all sorts of faith-based theories can flourish, even on Wall Street."

"Now Wall Street firms are primarily owned not by partners with personal capital at risk but by demanding institutional shareholders examining short-term results."

The first quote indicates that what we have here is a problem very similar to the Prisoner's Dilemma. People have two options: invest (e.g. take out a loan and buy a sweet house) or save (e.g. stick with your current house and mortgage). The way to maximize profit is to invest right up until the market crash (e.g. the ratio of investors to savers falls below a certain tipping point), and then shift to a saving strategy.

The second quote introduces the essential element of uncertainty. As in the Prisoner's Dilemma, if everyone knew exactly when the tipping point would be reached (the analagous case is knowing the exact number of iterations of the Dilemma you and your partner will face), then the rational thing to do would be to switch to saving immediately, precipitating an immediate market crash. Uncertainty makes it rational to continue to invest.

The last aspect, closely related to uncertainty, is that of timeframe. The longer one's planning timeframe, the greater the likelihood of a market crash - sure, this bubble probably won't burst in the next year, but in the next decade it's almost inevitable. Uncertainty is created by shorter timeframes. (In addition, one could talk about one's inductive timeframe - the distance into the past one looks to understand the present. Look only a few years and all you see are rising prices; look back decades and you see a business cycle).