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How to Game the Geithner Plan

The method can be found here. Here is how you do it:

Let’s say that I am a bank (“financial institution”) with $100 billion in “toxic assets”. I have them on my balance sheet at 80 cents on the dollar. The market has them marked at 30 cents. We do not know what the held-to-maturity performance will be, since that requires knowing the future, although for the moment let’s assume that they are cash-flowing at the present time.

What I (the bank) do know, however, is that if I sell them at 30 cents I take a monstrous loss – perhaps enough to force me under Tier Capital limits and thus render me subject to an FDIC enforcement action. I therefore will not sell for 30 cents so long as I have any belief whatsoever that the cash flow – or any government subsidy – will exceed that value.

If I, as a “financial institution” can participate as a bidder in these auctions I can foist off my loss onto the taxpayer. Here is how I can rig the game so as to avoid an otherwise-inevitable loss:

I become a “bidder” and “bid” on my own assets at 75 cents.
I am providing 5 or 10% of the money. The rest is covered by Treasury, The Fed and the FDIC via guaranteed bond issuance.
The loan, ex my contribution, is non-recourse. That is, I can lose 5 or 10% of the total portfolio purchased, but nothing more.
Now the “assets” (a passel of CDOs?) turn out to be worthless. I lose 5% of $75 billion, or $3.75 billion that I put up, plus the other nickel on the original mark, but that’s all.

The taxpayer gets hosed for the remaining $71.25 billion dollars.

This reminds me of the California electricity market back about 8 or 9 years ago. At that time the major utilities had to buy any and all electricity they needed on the spot market. Further their retail price was fixed by law. On top of that the state is constrained in terms of both tranmission and generation capacity. With a flexible price wholesale market (i.e. the spot market) and a fixed price retail market and that any single generator can influence the wholesale market price it shouldn’t take a genius to see that a problem will arise. For example, imagine you have an estimated demand of 1,000 MW. Suppose there are three providers each capable of generating 400 MW each. Two of them bid in 400 MW at $50/MW. The last guy bids in 200 MW at $1,500/MW. Now the market clears and all the generators get $1,500 MW. The retail market however can only collect about $40-50/MW. Since final consumers see the fixed retail price they have no incentive to cut back–i.e. no demand response. The utilities were put into a serious bind. However, for the consumer/taxpayer their situation of avoiding such prices was to be short lived. Established rate doctrine allows any utility to recover any costs that are deemed reasonable. And the way things were in California at the time all purchases of power off of the spot market were deemed reasonable irrespective of price. Now California has ridiculously high electricity prices.

Back to the gaming of Geithner’s Plan by Karl Denninger,

I like the outline of this program if and only if it cannot be gamed in this or similar fashion. Provided that does not occur, this program has the potential to provide great benefit to both the banking system and our economy.

Karl, let me introduce you to my friend here called the Folk Theorem. The idea that any plan be made “gaming proof” is likely to be rather difficult at best. You see, any outcome is feasible in a repeated game which is what we have here. In other words, the number of outcomes is very, very large. The subset of ones where “gaming” takes place is also likely to be very, very large. As such the idea that all gaming can be prohibited is likely not going to happen.

Even if we prohibit the actual financial institutions that hold these toxic assets from bidding other players might figure out other strategies for gaming the system and capturing a nice windfall.

Photo by Flickr user vinduhl, used under Creative Commons license.

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About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research.

Comments

  1. Rick DeMent says:

    and yet you support “free market” capitalism which is “gamed” almost by the hour. It was created to be gamed.

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  2. Steve Plunk says:

    Notice how this free market capitalism is being game through government intervention. That’s usually how it’s gamed, with the assistance of elected officials or bureaucrats.

    How about we work on valuation of the assets and put aside certain regulatory hurdles until that’s done? Mark to Market? Suspend. High capital requirements? Suspend. Suspend both of these with full disclosure to investors. Everybody knows what’s going on while the proper valuation is done.

    It’s not as hard as government is making it seem.

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  3. Steve Verdon says:

    Rick,

    The only markets that can be “gamed” to a really significant level are ones where you have few players. A game with many players is much, much harder to game. Further, in a free market the gains from gaming would eventually be eroded away as any particular gaming strategy became more wide spread…with enough players.

    Gets us back to that “too big to fail” issue. Implicit in the “too big to fail” claim is that there are only a few (big) players in that “game” and hence any single player failing or dropping out is very bad for the others still in the game. In a game where you have a few big players it is like a game with just a few players.

    Steve P.,

    Notice how this free market capitalism is being game through government intervention.

    Correct. Both the California experience and the current potential Geithner plan are due to government. The plan is not going to come about save with government intervention.

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  4. Dave Schuler says:

    This is a commonplace device well known to anybody who’s done much buying at auction. When consigners can register as bidders, you’re only on the hook for the sellers premium when you bid on your own merchandise.

    There are any number of other ways to rig auctions including pools.

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  5. tom p says:

    Any system can be gamed Steve, by virtue of the fact that it is a system. All systems are created by humans, no human is perfect, ergo, no system is perfect. Add to that the fact that everyone is trying to game the system (some are more successful than others) before it even exists, and you get the imperfect result we call a “democratic republic”.

    Notice how this free market capitalism is being game through government intervention.

    And the alternative is what? 13th century feudalism?

    Both the California experience and the current potential Geithner plan are due to government.

    I don’t mind anyone poking holes in the “gov’t intervention” of both these situations. There are plenty of holes to be found. But Steve V, why do you find blame with the gov’t for not enforcing the law in the CA energy situation, when it was Enron that illegally gamed the CA energy markets? (Conspiracy of Fools)(great book, I highly recommend it) And why do you ignore the fact that all these businesses got us into this situation thru the unregulated CDO and CDS markets?

    Gaming the system… is just the way things are. We can fight it, but we can’t win (somebody will always find a hole in the system). We might as well rail against the lion trying to sneak up on an antelope so it can’t run away before it is caught, or the antelope that only feeds in open grassland where no lion can hide.

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  6. Tlaloc says:

    Simple solution-
    the first person to do this goes to prison. The second is shot.

    If that’s too hard to implement then the first company to try this (and everyone after) gets nationalized. Immediately and at no return to shareholders. I doubt it’d take more than one example to be made before shareholders of other companies crucified any executive who wanted to game the system.

    I’m sick of treating these shortsighted idiots as anything but what they are- criminals.

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  7. Steve Verdon says:

    Any system can be gamed Steve, by virtue of the fact that it is a system. All systems are created by humans, no human is perfect, ergo, no system is perfect. Add to that the fact that everyone is trying to game the system (some are more successful than others) before it even exists, and you get the imperfect result we call a “democratic republic”.

    In a trivial sense yes. However, if you are playing a game with 999 other players and none of them are particularly big–i.e. a dominant players, then gaming the system is likely to get you very little over a suitable time horizon. Usually you find these problems when there are few players, or a few dominant players.

    And the alternative is what? 13th century feudalism?

    No a reduction in government…at least discretionary government.

    I don’t mind anyone poking holes in the “gov’t intervention” of both these situations. There are plenty of holes to be found. But Steve V, why do you find blame with the gov’t for not enforcing the law in the CA energy situation, when it was Enron that illegally gamed the CA energy markets?

    I think the role Enron played was not nearly as large as people make out. Note the example I used, it wasn’t too far from reality. The market was set up to give various players, of which Enron was one, alot of market power. Another was LADWP. They made a huge amount of money during the CA energy crisis. So did others.

    And why do you ignore the fact that all these businesses got us into this situation thru the unregulated CDO and CDS markets?

    Because I don’t think we’d have gotten here without government demonstrating time and again a willingness to step in a bailout the big players.

    For example, suppose you have a distressed bank with lots of toxic assets. You have them listed on your books at $0.80 on the dollar. If you tried to sell them now you could get maybe $0.30 on the dollar. So do you sell knowing the FDIC might take you over? Or do you wait around and see if the government will throw bailout money at you thus prolonging the problem and the pain. Given that the government has bailed out lots of companies:

    S&Ls
    Airlines
    Chrysler
    etc.

    You might just decide to play the waiting game. To make matters worse the government decided not to bailout Lehman adding to the uncertainty.

    Sure we might be in a recession right now if we had less government, I happen to think it wouldn’t be as bad. The market itself is a type of regulator: screw up bad enough and you’re out.

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  8. Steve Verdon says:

    Tlaloc,

    An easier solution is to disallow the financial institutions as bidders. After all, we don’t want any “I’ll bid on yours if you bid on mine.” wink, wink, nudge, nudge

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  9. Dave Schuler says:

    An easier solution is to disallow the financial institutions as bidders. After all, we don’t want any “I’ll bid on yours if you bid on mine.”

    That’s one form of pooling.

    That brings up a larger question: who is a qualified bidder? If we disqualify financial institutions there may not be any qualified bidders. And how do we define “financial institution”? Is disallowing the owners of the “toxic assets” enough? Frankly, I doubt it.

    Tlaloc, at least putatively we have a rule of law here in the U. S. The law would need to be written in such a way as to preclude simple sorts of gaming. I think that’s what we’re discussing here.

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  10. Tlaloc says:

    An easier solution is to disallow the financial institutions as bidders. After all, we don’t want any “I’ll bid on yours if you bid on mine.” wink, wink, nudge, nudge

    That’s addressing a symptom, not the disease, Steve. The disease is the rampant and flagrant irresponsibility fostered by a system of no accountability (beyond to shareholders, if even then) in which the high financiers operate. These guys have destroyed lives because they didn’t feel like they were getting rich fast enough. They cut corners and avoided regulation to improve their profit margins and the obvious happened- it blew up. But because of who they are it didn’t just blow up in their faces.

    It’s time to establish that profit is not an okay motive when making decisions that affect every human being on earth. Actually it’s a few hundred years past time to make that explicitly clear.

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  11. Tlaloc says:

    Tlaloc, at least putatively we have a rule of law here in the U. S.

    It’d be a whole lot easier to believe that if these people, who destroyed more lives than all the drug dealers we currently have in prison, were facing jail time instead of multimillion dollar bonuses.

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  12. Steve Verdon says:

    That’s addressing a symptom, not the disease, Steve. The disease is the rampant and flagrant irresponsibility fostered by a system of no accountability (beyond to shareholders, if even then) in which the high financiers operate.

    Tlaloc,

    You aren’t going to change that so long as government and high finance, as you put it, are so nice and cozy. You’ve just seen that it isn’t really the military-industrial complex you have to worry about, but the treasury-federal reserve-financial complex you have to worry about.

    After all the government keeps bailing these guys out. I presume you prefer Obama to McCain so even the guy you’d rather have in office “plays the game” so to speak.

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  13. odograph says:

    As the token centrist (surely I can’t be the only one?), I’d point out that the economy can be gamed whenever the balance isn’t right. We don’t want too much government, but neither do we want businesses who answer to no one.

    There are a number of ways to get the balance wrong. Let’s see … I readily accept the ethanol fiasco as a too much government gaming of the food and energy economy. And I accept the whole mortgage backed securities fiasco as businesses running wild without oversight.

    We are coming off a fairly dysfunctional age, and working through some fairly dysfunctional solutions … but I don’t think it is outlandish to say that the answer should be a balanced market economy, going forward.

    (BTW, I’m sure some of you could offer myths of government responsibility for the mortgage and credit crises. I’d buy some as factors, but in the end there absolutely was no binding law requiring anyone to sell, or to take, a bad loan. Period.)

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  14. odograph says:

    BTW, “balance” doesn’t imply Steve’s cosiness. It probably should be an adversarial balance, in order for it to work at all.

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  15. Wayne says:

    Why not bid 110 cents on dollar? You are buying from yourself with someone else’s money.
    It strikes similar to this. If I bought $10 in lottery tickets and they didn’t win, then offer to go in with someone to buy them from me for $11 and I will throw in %10 ($1) of the purchase.

    Nothing but a scam.

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  16. tom p says:

    In a trivial sense yes. However, if you are playing a game with 999 other players and none of them are particularly big–i.e. a dominant players,

    Steve, there are dominant players, like BoA, Chase, Goldman/Sachs, AIG, and there is nothing trivial about it. Remember “too big to fail”? I know, you don’t agree, but that is not my point here, my point is there are always dominant players (Microsoft anyone?)… You don’t have to like it, but it is a fact, and we need to deal with it. How does one get around that fact? More gov’t regulation? No more too big too fail? Is that what you are arguing for? I know better… but what is your solution?

    And the alternative is what? 13th century feudalism?

    No a reduction in government…at least discretionary government.

    But what is discretionary Gov’t? That covers a wide spectrum, one I am willing to bet Microsoft can cover.

    I think the role Enron played was not nearly as large as people make out. Note the example I used, it wasn’t too far from reality. The market was set up to give various players, of which Enron was one, alot of market power. Another was LADWP. They made a huge amount of money during the CA energy crisis. So did others.

    And did they not all break the law? (this is an honest question, I am not that well versed in the particulars of the situation) Either way, it proves my point… namely that what they did was illegal, or they gamed the system. Which is it?

    Because I don’t think we’d have gotten here without government demonstrating time and again a willingness to step in a bailout the big players.

    And Steve, here is where you and I agree. The problem is, what is the solution? Gov’t stepping in and making sure nobody gets “too big to fail” before they fail? Or after? Because that seems to be where we are right now, and I don’t see an easy way out of it.

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  17. Tlaloc says:

    You aren’t going to change that so long as government and high finance, as you put it, are so nice and cozy.

    No disagreement, which is why I’d like the relationship between government and high finance to resemble that of a mountain lion and a steak.

    You’ve just seen that it isn’t really the military-industrial complex you have to worry about, but the treasury-federal reserve-financial complex you have to worry about.

    Well the MI is no picnic. It causes the majority of our foreign policy troubles.

    After all the government keeps bailing these guys out. I presume you prefer Obama to McCain so even the guy you’d rather have in office “plays the game” so to speak.

    Personally I voted third party because I didn’t trust Obama to actually do what needs to be done. I completely agree that both parties are far too fascist (supporting corporate control or co-option of government).

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  18. Rick DeMent says:

    Notice how this free market capitalism is being game through government intervention.

    At the direction of the big players in the FIRE sector. Government is a servant of FIRE not the other way around.

    The only markets that can be “gamed” to a really significant level are ones where you have few players. A game with many players is much, much harder to game. Further, in a free market the gains from gaming would eventually be eroded away as any particular gaming strategy became more wide spread…with enough players

    To paraphrase the Jester: The level of naivety required to believe the above statement is only found in 1970’s porno films. Ex. “You mean for the time machine to work I have to take off * all * my clothes”?

    Steve have you ever actually ran a business? Seriously. I mean even at the little company I worked at in the 90’s the owner was in bed with government on all levels and the crap that went down was unbelievable.

    Our government is paid for by big business, and gets it’s monies worth.

    And one last thing we don’t have a free market, we haven’t had a free market since we stopped bartering with the natives (unless your count the parking lot of a Grateful Dead concert in the 70’s). So feel free to take you economic models based on the notion of a free market and flush them, they are doing you a disservice.

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  19. Steve Plunk says:

    I’m not sure of Rick D. is asking me or Steve V. if one of us has ever ran a business. I have and do. A heavily regulated trucking business. I watch other businesses that work with government and see them doing some of the most dishonorable things which I could never be a part of. The thing is I don’t blame the businesses as much as the government for those “partnerships”.

    The term “big business” always sets off alarm bells for me. Business is too diversified to lump together in such a way. That term has been a generic slander for years and serves no real purpose. Small businesses like my own are the backbone of American commerce yet we don’t get respect from our government.

    It’s true we don’t have a completely “free market” but we are always moving toward or away from one. This gaming of the system with government help is wrong and should be a lesson for us to move the other way, toward a more free market. Government regulations should be geared more toward disclosure than fairness (think Fannie and Freddie lending practices).

    If business itself works to gain advantage we can choose not buy or buy elsewhere. With government in the picture we lose that ability. That’s what makes it so disturbing, the enabling by politicians and bureaucrats who use force of law.

    One last thing, our government is no more bought and paid for by big business than it is by organized labor, the environmental lobby, or any other group with deep pockets. The blame for that lies with the politicians and no where else. I’m so tired of hearing the phrase “public service” or “public servant” when in fact these people serves themselves before anyone else.

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  20. Steve Verdon says:

    tom p,

    Steve, there are dominant players, like BoA, Chase, Goldman/Sachs, AIG, and there is nothing trivial about it.

    Yes I know. Now would you either stick to a theoretical construct as you initially suggested or real life? I’ve already noted in a post that part of the problem is that we have these entities that are too big to fail. Further, I’d be willing to bet that our legal, regulatory, and institutional environment encourage too big to fail.

    I know, you don’t agree, but that is not my point here, my point is there are always dominant players (Microsoft anyone?)

    No, my comment was about your comment about “any system being gamed”. Trivally the statement by you is true, but it is only a problem when you have large/dominant players. You’ve shifted the context of the discussion.

    But what is discretionary Gov’t? That covers a wide spectrum, one I am willing to bet Microsoft can cover.

    Where politicians make decisions as to how government reacts to a situation. I’d prefer basing things on rules vs. letting politicians who are subject to the whims of public opinion and the desire for re-election to not necessarily pursue the best or at least less costly approach.

    And did they not all break the law? (this is an honest question, I am not that well versed in the particulars of the situation) Either way, it proves my point… namely that what they did was illegal, or they gamed the system. Which is it?

    In Enron’s case some of it was illegal, for other market particiapants it was merely exercising market power which is not necessarily illegal. Example: LADWP. AFAIK, nothing has been done to LADWP nor is there anything suggesting they did anything illegal…but they sure did make billions of dollars.

    And Steve, here is where you and I agree. The problem is, what is the solution? Gov’t stepping in and making sure nobody gets “too big to fail” before they fail? Or after? Because that seems to be where we are right now, and I don’t see an easy way out of it.

    Bailouts, as they have been done for past couple of decades, have been a good example of discretionary policy. Instead of having a play book to fall back on the rules/decisions are made up as they go along. Perhaps somewhat understandable the very first time, but after that come up with some rules that can be followed and stick to them. It reduces uncertainty and can help reduce problems with moral hazard. Problem it isn’t in a politicians self-interest. Which is why I laugh at people who think “if we just get the right guy….” There is no right guy by definition, IMO.

    Tlaloc,

    Well the MI is no picnic. It causes the majority of our foreign policy troubles.

    Maybe so, although this could be debatable…how exactly did Hitler come to power? If it hadn’t been for the Versaille Treaty and the Great Depression might the Germans have just written him off as a whack job?

    Personally I voted third party because I didn’t trust Obama to actually do what needs to be done. I completely agree that both parties are far too fascist (supporting corporate control or co-option of government).

    No disagreement on this point for me. I suppose we differ on how thing should be done, but at least we see the current situation as…unpalatable, to put it mildly.

    Rick,

    At the direction of the big players in the FIRE sector. Government is a servant of FIRE not the other way around.

    I’d say at this point the relationship is symbiotic.

    Steve have you ever actually ran a business? Seriously. I mean even at the little company I worked at in the 90’s the owner was in bed with government on all levels and the crap that went down was unbelievable.

    With the government following discretionary policy it is the ultimate in terms of dominant player. Factor in the incestuous nature of employment between the financial sector and government and you have a serious potential for very large problems. You seem to think that the goverment is going to help you, when you point out that it is part of the problem. You seem a tad confused.

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  21. Rick DeMent says:

    You seem to think that the goverment is going to help you …

    Never said that.

    …when you point out that it is part of the problem. You seem a tad confused.

    What I’m saying is that government is incapable of doing anything counter to the interests of those who finance campaigns. The government is not for or against the FIRE sector (other other large business entities) it *is* those things. The government can only work in the public interests if those interests happen to consider with those of the large economic concerns who finance the campaigns. (or of the issue is something they don’t give a flip about like Abortion or gays).

    You the one who is confused my friend. you seem to think that wall street quakes in their boots over what government might do. Sure that’s what that want you to think (and people like you are gullible enough to believe it). But the “government” shines their shoes not the other way around.

    The solutions to the banking situation (if the problem is narrowly defined as allowing sufficient credit to flow) is simple. Unfortunately the Financial Sector wont allow the government to do anything counter to their interests so they have to come up with some Rube Goldberg deal to try and fix it. I am crystal clear on the issue, the government has no power to do anything that make the FIRE sector answer for their mistakes, that is the “one arm tied behind the governments back”.

    And I guess the answer is no, you have never run a business … though so.

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  22. Steve Verdon says:

    You the one who is confused my friend. you seem to think that wall street quakes in their boots over what government might do.

    Nope. Never wrote anything that implies that. You’re wrong.

    The solutions to the banking situation (if the problem is narrowly defined as allowing sufficient credit to flow) is simple.

    I’m guessing nationalization. There you go again thinking government will help, but then saying it wont. I’m not confused. You are with cryptic-socialist views…or whatever they are.

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  23. tom p says:

    A couple of points.

    Now would you either stick to a theoretical construct as you initially suggested or real life?

    Steve, as you well know I am not an economist, or a financier… I look at the real world and I see it as I percieve it. I look to people like you (and others) to help explain the ins and outs of it to me. But in the end, I am left with the real world facts, and it is up to me to come up with a “theoretical construct” that explains these real world facts. I do not come up with these “theoretical constructs” out of thin air, rather I try to base them on “real life” facts… (I may be wrong, but nothing you have said directly repudiates any of my assertions)

    My “real life” experiences tell me that “the man with the gold, makes the rules.”

    You are far more knowledgeable than I about business, but my gut tells me that if you haven’t learned the “golden rule”, the rest of your knowledge is beside the point… For instance:

    No, my comment was about your comment about “any system being gamed”. Trivally the statement by you is true, but it is only a problem when you have large/dominant players.

    Steve: Real world fact: There are always dominant players, and there is nothing trivial about it. Get used to it. The fact that you seem able to seperate “real world” from “theory” worry’s me. All systems are gamed. Do what you can to make the “game” more fair, but please, stop railing against the fact that there is a game. That is “Denial” and no, it is not a river in Egypt.

    Where politicians make decisions as to how government reacts to a situation. I’d prefer basing things on rules vs. letting politicians who are subject to the whims of public opinion and the desire for re-election to not necessarily pursue the best or at least less costly approach.

    I would agree, but I cannot help but notice that you don’t seem to have a problem with the whims of “business” influencing politicians????

    It.is.a.game.Steve. If you can’t admit that, we can hardly have a dialogue. I don’t expect us to agree on everything, but a denial of the out and out obvious, makes me think this is not a serious discussion, but an exercise in futility.

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  24. Steve Verdon says:

    But in the end, I am left with the real world facts, and it is up to me to come up with a “theoretical construct” that explains these real world facts.

    You were the one that brought the theoretical possibility of gaming markets. I replied on a theoretical level, then you switched to real life to try and undermine my theoretical comment.

    Steve: Real world fact: There are always dominant players, and there is nothing trivial about it.

    No, not always. Also, the trivial referred that its always going to be true in any game at some level. It is like saying all human knowledge is wrong, at least in some minor way. Trivially this is true, but there are lots of things humans know that are more than accurate enough to be both useful and accurate enough that the error is not worth worrying about.

    Get used to it.

    I am, you are misunderstanding my point.

    The fact that you seem able to seperate “real world” from “theory” worry’s me.

    All theory is seperated from the real world…that is the point. If you were going to develop theories that were in perferct accord with reality there’d be no need for such theories, just use reality. But reality is messy and complicated so abstracting from reality to some degree makes the problem tractable. Think of like building a house. Do you build it all at once, or do you start with the foundation, then the walls, then the roof?

    All systems are gamed. Do what you can to make the “game” more fair, but please, stop railing against the fact that there is a game. That is “Denial” and no, it is not a river in Egypt.

    I don’t believe I’ve done this.

    I would agree, but I cannot help but notice that you don’t seem to have a problem with the whims of “business” influencing politicians????

    With rules it would mitigate this too. The businessman goes to the politician and the politicians says, “Sorry, that is determined by that rule over there. And to change it you’ll need more than just my vote, but a two thirds majority.”

    I have no issue with looking at these issues as games and using the language of game theory to help better understand them. I think you’ve misunderstood my view rather early on. I’m extremely comfortable with the idea of thinking of things as a game and relying on game theory. Please, re-read what I wrote keeping this in mind. I think you’ll see some of our major disagreements aren’t nearly so major.

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