How Game Theory Applies to Money

How Game Theory Applies to Money

This is the fifth entry of my series, The Future of Money.
Here’s a quick recap of what we’ve covered so far:

  1. What Is Money?
    Money is humanity’s best attempt to preserve time through an agreed-upon medium of exchange.
  2. A Brief History of Money
    The first form of collectibles was believed to originate 40,000 years ago and were originally used to transfer wealth. Coins were first used in 700 B.C. in Lydia, and were a more efficient money.
  3. Does Money Have Intrinsic Value?
    Value is largely subjective. Gold’s value comes from the collective belief it will retain purchasing power, trading on its historic brand.
  4. Money vs. Currency
    To qualify as money, the chosen currency must be a store of value, which requires scarcity. All fiats have historically failed or been dramatically devalued while gold and silver have maintained their purchasing power.

Game theory is a framework for decision-making in situations where competing players are motivated by differing incentives.

Pioneered by John von Neumann, game theory was developed as he aimed to solve the problem of bluffing in poker, a situation in which one has imperfect information, yet still has to make a decision.1 It just so happens that I’ve played poker professionally for nearly 20 years, so I’ve gotten to see the applications of this phenomenon first hand countless times.

When playing poker, my objective is to understand the tendencies of my competition and design a strategy to outplay them.

For example, if I discover my opponent bluffs too often, I’ll begin calling him down more. This approach works against inferior players who have easily exploitable betting patterns. Against top professionals, however, things aren’t so simple.

Imagine my thinking opponent begins our match by bluffing 100% of the time. I adjust by calling more. Upon seeing that I never fold, he’ll switch to betting exclusively with premium holdings, at which point I’ll readjust by folding more. As this pattern continues, less time will pass between each subsequent adjustment until we’re both changing our game plan hand by hand.

Now he’s forced to adopt a mixed strategy, betting with both strong and weak holdings to avoid being too predictable. The only way for me to counter is by calling with my strong hands and folding my weaker ones.

Taken to the extreme, if two supercomputers were playing against one another, they would inevitably reach a point where both machines adopt a perfectly balanced strategy, neither bluffing too often nor too little, neither calling nor folding too frequently, resulting in neither machine having an edge over the other.

Poker players call this a game theory optimal (GTO) strategy, and top professionals use it when they believe no edge can be gained by exploiting the opposition’s weaknesses.

In game theory, this is referred to as the Nash equilibrium. Named after the mathematician John Forbes Nash Jr., the Nash equilibrium is a solution in non-cooperative games in which each player is assumed to know the equilibrium strategies of the other players, and therefore, no player has anything to gain by changing his own strategy.

Game Theory and Money

What I didn’t expect in studying game theory was that it would help me to understand money.

The logic behind why a professional poker player uses game theory can also be applied to a society’s choice for money.

In game theory, a focal point (often referred to as a Schelling point, named after Thomas Schelling) is a solution that people choose by default in the absence of communication. A society operates much like a poker game in that there are independent actors with competing incentives who need to coexist in a world where two parties cannot necessarily trust one another. 

When it comes to choosing a type of money, game theory teaches us that people are incentivized to choose the option that is both the most efficient and best maintains its value.

Failure to store value in the hardest money will result in losing one’s wealth as the inferior money gets replaced by a better one. Inevitably, the most efficient money will win in the long run, just as the player utilizing the best poker strategy inevitably pulls ahead over a large enough sample size.

We can illustrate this phenomenon with a simple thought experiment.

Imagine the members of a tribe are debating whether gold or aluminum would better serve as money. They can’t agree, so they use both with an exchange rate of 1:1. It’s obvious how this plays out: The aluminum corrodes, and they eventually end up using gold.

It’s important to realize that the most efficient money would inevitably win, regardless of which of the seven characteristics it best represents.

For example, should a tribe be divided between gold and another non-corrosive material (such as rocks), people would spend the rocks (which are less scarce and whose supply can be manipulated) and hoard the gold. This is known as “Gresham’s Law,” a monetary principle that can be summed up as “good money drives out bad.” 

In other words, people will spend the item of lower value (rocks) while hoarding the more precious asset (gold).

Put simply, gold has historically been the game theory optimal choice for money because no other option has yet proven itself to better satisfy the criteria of money.

Key Takeaway: Game theory dictates that people are incentivized to use the optimal strategy in situations where they cannot trust others. Choosing a money supply is one such situation where game theory must be used, and as a result, the chosen money will end up being the one which best satisfies its seven characteristics (fungible, portable, durable, divisible,  acceptable, uniform, scarce).

Question to Ponder: If a more optimal way of storing value existed, would people opt to use it in place of gold?

What Does the Future Hold?

I’m on this journey, just like you, but here’s what I’m seeing, along with some of the lingering questions I have based on my observations.

In the near term, an exploitative approach to money can be profitable, just as a poker player can get away with a one-off bluff. It seems to me that this is what’s happening in our society today.

As central banks buy gold at unprecedented levels—a process which suspiciously commenced during the last financial crisis in 2008, during which there money was printed excessively—one can’t help but wonder if it’s possible that they are merely “outplaying” the public, getting first dibs on the game theory optimal store of value while the rest of us hold paper. 

Over time, just like that poker player’s betting patterns will be discovered, will the market eventually gravitate toward the Nash equilibrium and choose the best money?

How long can continual debasement of our currency persist before eventually, like it has every single time in history, fiat currency fails, and in a panic, people revert to the scarcest way to store their wealth? What is the tipping point, and what steps can we take to ensure we protect ourselves? Is it only sensible that we follow in the footsteps of these “professionals” and mimic their purchasing behavior?

In the wake of the COVID-19 pandemic, the central banks are again printing historic amounts of currency. We live in a unique time in which not just the U.S. dollar, but all of the world’s currencies, are backed solely by faith. How much currency can be printed before inflation rears its ugly head and people lose their purchasing power, eventually storing their wealth somewhere else? With bond yields virtually nonexistent, and stock market and real estate valuations at all-time highs, where will people turn to balance their portfolios and seek returns?

If members of countries around the world lose faith in their local fiat, are they really going to run to another fiat like the U.S. dollar?

Temporarily, perhaps, but isn’t this just another blip on the timeline until they rush to “hard” money, like an amateur poker player’s last bluff before he ultimately gets caught?2 What happens if the entire monetary system needs to be reformed because there’s simply too much unsustainable debt? What will that mean not just for the price of gold, but for all other scarce assets?

My personal belief is that the truth always wins (provided that there’s a long enough time horizon). It’s often said that the definition of insanity is doing the same thing over again and expecting a different result. Why should I expect this time to be different?

Trust is hard to gain, yet easy to lose. Once people stop trusting fiat, they never trust it again.

Therefore, the group of people looking for an offramp to fiat is ever increasing. This awakening by society is happening—slowly—but it’ll increase in speed and then end suddenly, like it has throughout history.

Or, maybe I’ve got it all wrong. And as Stephanie Kelton advocates as part of Modern Monetary Theory (MMT), our national debt and deficiency matter less than we’re taught to believe, and we can essentially keep printing until the economy is at full employment.3 

You’ll have to decide where to place your bets.

I’m learning day by day, and I’d love to hear your thoughts on this subject. Please, leave them in a comment below.

In my next entry, The Future of Money, we’ll ponder some more questions together, such as, “Does a more efficient form of money exist?” If so, what would it look like? What could its potential value be?

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Alec

  1. Theory of Parlor Games 1928, John Von Neumann
  2. The Dollar Milkshake Theory: https://www.youtube.com/watch?v=vDr3lRZ01Zo
  3. Stephanie Kelton – MMT and the Deficit Myth: https://www.youtube.com/watch?v=28atgck_1lA

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