The Prisoner’s Dilemma is a classic game theory scenario which postulates that two people would not cooperate with each other—even if it is in their best interests to do so. Consider this situation: Two suspects are arrested by the police. The police have insufficient evidence for a conviction, and, having separated the prisoners, visit each of them to offer the same deal. If one testifies for the prosecution against the other (defects) and the other remains silent (cooperates), the defector goes free and the silent accomplice receives the full 10-year sentence. If both remain silent, both prisoners are sentenced to only six months in jail for a minor charge. If each betrays the other, each receives a five-year sentence.
Given that each prisoner is only concerned with maximizing his own payoff, the rational choice is to defect. Should one prisoner cooperate, the second prisoner should defect in order to reduce his jail time to 0. Should the first prisoner defect, the second prisoner should also defect in order to reduce his jail time from 10 years to 5 years.
Our economy currently has its own Prisoner’s Dilemma; one in which each individual will act rationally, but with little consideration of what is in his or her best interest.
The ends of recessions have very high correlations to increases in residential investment and personal consumption expenditures. More specifically, residential investment as it pertains to new manufacturing of homes. The amount of existing inventory—and shadow inventory—combined with the rate of increase in new home inventory between 2003 and 2007, will render the impact of new housing investment negligible in coming out of this recession. Therefore, it stands to reason, that personal consumption expenditures will need to pick up the slack. Herein lies the dilemma.
With economic concerns abound, the individual is less than eager to live beyond his means. To understand this dynamic more definitively, one could analyze the personal savings rate. In 2005, the personal savings rate calculated by the Bureau of Economic Analysis was 1.38%. For the first five months of 2010, the average savings rate was 3.66%. Delaying, or reducing, personal consumption will only lead to a more questionable economic condition; which, in turn, will lead the individual to further solidify his own balance sheet. This is a perilous negative feedback cycle.
However, in iterated versions of the Prisoner’s Dilemma, there are several factors that tend to produce the best possible outcome for the individual prisoner over a period of time—not the least of which is the characteristic of being cooperative. In other words, the individual prisoner must act irrational in the short-term in order to maximize his payoff in the long-term.
Ryan Lampkin is the Chief Investment Strategist at Castle Asset Management. Castle Asset Management is a discretionary asset manager and SEC Registered Investment Advisor located on Long Island.