The Calculus Diaries - Jennifer Ouellette [54]
VIRTUAL WEALTH
The fallout from Holland’s tulip mania crash was limited to a few overly enthusiastic traders and wealthy collectors. That’s because the Amsterdam Stock Exchange back in 1630 had the good sense not to get involved with the rampant speculation in tulip bulbs, marginalizing the economic impact when the bubble burst. Most Dutch traders were able to negotiate settlements for their debts, although the price of bulbs continued to fall for decades after the crash. Financial ruin hit those who had invested elsewhere while relying on the profit they expected to make on their tulip bulbs to pay those debts—profit that never transpired.
That was the problem with the housing bubble: People speculated on the market, tapping into the equity on their homes to finance other projects—a new car, a lavish vacation, a kitchen remodel, an investment in a second rental property, or a vacation home. When the market crashed and their home values plummeted, those home owners found themselves owing more to the banks than their homes were worth. They had negative equity. Furthermore, investment banks had packaged those mortgages into complicated financial instruments that were sold to investors around the world, so when the waves of foreclosure hit, the massive losses incurred over a short period of time brought the global economy to its knees.
Economists are going to be analyzing this housing market crash for decades before they fully understand how and why it happened. But anyone observing the virtual economy in the online game Second Life could glean some valuable insights, according to Cornell University economist Robert Bloomfield. He believes virtual economies like those in Second Life can provide useful simulations of the patterns of free markets—and the consequences of failing to self-regulate. In Second Life, players can buy virtual currency with their real-world dollars—250 “Linden dollars” roughly corresponds to one U.S. dollar. They buy and sell goods and services and engage in online investment schemes without all the pesky regulations hampering the free market in “meat space.”
And therein lay the problem. In 2007, an in-game virtual investment bank, Ginko Financial, collapsed. The bank promised investors a whopping 40 percent return on their Linden money and made loans to other players at equally exorbitant rates. When those players failed to repay their virtual loans, investors panicked and made a run on Ginko to withdraw their funds, quickly outstripping the bank’s reserves. Nor were the losses purely virtual, since Linden dollars were purchased with real currency: Investors collectively lost the equivalent of 750,000 U.S. real-world dollars.
Second Life creator Linden Lab responded by banning any virtual banks promising interest rate returns on deposits to investors. One year later, in the wake of the mortgage meltdown, revered financial titan Alan Greenspan reluctantly came to a similar real-world conclusion: Lending institutions cannot be trusted to regulate themselves—not because the free market doesn’t work, but because certain unscrupulous people cheated and “gamed” the system. It is human nature that is at fault, more than free-market economics. It makes a strong case for factoring irrational human behavior into any viable economic model. In fact, the burgeoning new field of behavioral economics focuses on studying how and why human beings don’t always act in their best self-interest.
The parallels to our real-world economy are admittedly imperfect, but the economic lessons drawn from Second Life are compelling, because it is a model built from actual human behavior—raw data—not a programmed computer simulation. People do not always behave rationally (or nobly), and many economic theories fail to take this into account. Jonah Lehrer, author of How We Decide, asserts that the problem lies less with the actual models and more with the human brain. “People love models, especially when they’re big, complex, and quantitative. Models make us feel safe,” he writes.