From Ginko to WaMu

It was the biggest bank failure in history, and it came on the eve of a series of very bad days for U.S. investors. On September 26, 2008, JPMorgan Chase acquired all the banking operations of Washington Mutual (WaMu), including $307 billion in assets and $188 billion in deposits. The fall of WaMu was the latest turn in a series of bank failures: the bankruptcy of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America and the near collapse of insurance giant AIG.

From Ginko to Wamu

A similar but much less sweeping series of bank failures occurred about a year earlier in the computer-generated virtual world known as Second Life. Ginko Financial — an unregulated virtual bank that promised investors real money in returns in excess of 40 percent — declared insolvency and was forced to repay $200 million in an internal currency called Linden dollars.

Second Life, established in 2003 by Linden Lab, is one of the first mainstream virtual worlds. In addition to its own currency (which can be converted to U.S. dollars), it has a fledgling economy built around virtual goods. To buy or sell goods or services, you create a 3D graphical representation of yourself known as an avatar. Avatars can change appearance, talk with other avatars, and walk around inside of user-generated environments. More importantly, avatars can pay each other in Linden dollars.

$200 million in Linden dollars may sound like a hefty sum for a computer-generated world. In fact, it is a mere $750,000 U.S. dollars. In response to the Ginko failure, Linden Lab shut down dozens of banks in Second Life. Although virtual, the banks were funded by real money. According to a new policy, Second Life residents cannot accept deposits in exchange for a promise of repayment with interest unless they provide proof of real world regulatory oversight.

What can we learn about real world economics using the simulations provided by virtual worlds? Metanomics is an emerging — even edgy — field of academic study that deals with the economic, legal, and regulatory issues of virtual worlds. Professor Robert Bloomfield, host of a weekly webcast on Metanomics, oversees Cornell University’s Johnson School doctoral program and directs its business simulation laboratory. Bloomfield, trained in experimental economics, sees both the realism of a field experiment with the control of a lab experiment in virtual worlds, "I have been studying this space for, I guess, over a year now, and I think it’s very exciting."

A similar but much less sweeping series of bank failures occurred about a year earlier in Second Life.

Bloomfield’s avatar name is "Beyers Sellers," a nod to Nobel prize-winning economist Vernon Smith – Smith studied the behavior of buyers and sellers who bid competitively on fictitious commodities. Bloomfield calls Second Life markets a fascinating experiment in libertarianism and self-regulation. He says that everything he needed to know about the current real world credit crisis he learned from virtual worlds, “Investors were all too willing to believe that they would earn their high interest rates, and bankers and borrowers, no doubt, were too willing to believe that the borrowers could pay the high interest rates demanded of them.” Lack of regulation and subversion of honest financial dealings by a corrupt few in the interest of profit — sound familiar?

While Bloomfield’s experimentation focuses on financial economics, how financial markets behave, and how they respond to regulations, Thomas Chesney of Nottingham University Business School is conducting experiments in behavioral economics using Ultimatum and Dictator games to examine fairness and altruism. In an Ultimatum game, individual A is given a sum of money and asked how s/he wants to split it with randomly paired person B. If the offer is rejected by person B, no one gets any money. In a Dictator game, person B has no choice but to accept the offer of person A. In tests conducted in both, Chesney found no statistical difference between the outcomes in Second Life and real life.

Ginko Financial and the other bank failures in Second Life were precipitated by a ban on gambling and shady business practices that bordered on fraud. WaMu failed under the weight of its enormous bad bets on the subprime mortgage business. In both cases, perhaps a trip to Las Vegas might have been a safer investment strategy. By studying the effects of self-regulated markets and fairness and altruism in virtual worlds, future experimental economists may be able to help guide real world policy to avoid more failures like WaMu.

Surfdaddy Orca is a virtual worlds explorer and science writer.

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