Everything I needed to know (about the credit crisis) I learned in Second Life

This is the text of my "Connecting the Dots" editorial from the Sept 22nd edition of Metanomics. Sure, it oversimplifies a complex issue, but sometimes that is a useful thing to do.

My guess is that you have all heard about the global credit crisis. Many of you have probably also heard of the book ‘ Everything I needed to know I learned in kindergarten.’ Let me be the first to draw the two together, and add in a dose of Second Life.

Author Robert Fulghum makes the point that the most fundamental rules that help us navigate life are taught to us when we are very young. His list includes: Don’t be greedy. Play fair. Look both ways before crossing the street. Clean up your own mess. And nap every afternoon.

Kindergarten is a pretty simple place. So when the kids start crying, it’s pretty easy to trace how violations of these basic lessons caused any problems you see in the classroom. Well, grownups are crying in the real world today because of the global credit crisis. But it’s hard for most people to see why, because even though people violated simple rules, but they did it in a very complicated setting. My hope to shed a little light on the issue by looking at a similar crisis, but in a much simpler world: the financial markets of second life.

Let’s start with a brief history of Second Life finance.

By July of 2007, virtual firms that did business entirely within Second Life firms had raised several million US dollars worth of capital from thousands of residents. How did they attract all that capital? One banker I interviewed on Metanomics was paying over 350% interest per year. He afforded it by charging his borrowers over twice that much. Not surprisingly, it couldn’t last. Over the course of the year, most of the banks had shut down, leaving investors with nothing, or with nearly worthless IOUs.

Firm after firm that had issued stock dissolved, again leaving investors with nothing. Even the mainstream press has taken notice of Ginko Bank, which is said to have singlehandedly caused $750K of losses—that’s US dollars. My own analysis of Second Life Capital Exchange shows that the only people who avoided large losses in the equity markets were the people who issued the stock.

How could this happen? Well, many people were greedy. Investors were all too willing to believe that they would earn their high interest rates. Some bankers and borrowers no doubt were too willing to believe that the borrowers could pay the high interest demanded of them. Some of them probably weren’t playing fair, too.

Of course, a major problem was that most investors didn’t look both ways before crossing the street. In part, that was because they there just wasn’t a good enough system of financial reporting to give them clear enough vision to see the bus coming at them, and there was no crossing guard to warn them.

When the bus came, it didn’t just run over the greedy. The thing to understand about credit markets is that they are self-reinforcing. As long as things are going well, everyone is rich enough to be able to buy, lend, invest and grow. But if you knock a few blocks out from underneath the market, everyone loses confidence, and the whole thing can collapse. So the architects of the Second Life financial markets violated another rule most kids learn in kindergarten: When you’re building something, put the biggest, strongest blocks on the bottom!

Implicit in all of Fulgham’s lessons is a more basic one: listen to the grownups, they’re there to help you and keep you safe. But Linden Lab, the overseers of Second Life has chosen a different philosophy: just let kids be kids, and learn to sort it out themselves.

That made the Second Life markets a fascinating experiment in libertarianism and self-regulation. Economists have made some very compelling arguments that we don’t actually need regulations to guarantee transparent and reliable financial reporting. The firms that are trying to raise capital will impose those regulations themselves, so that they can raise more capital more cheaply.

Well, that theory played out pretty poorly in Second Life. One reason is that so many people are greedy, and are willing to believe promises of easy profits. Why be transparent and reliable if you can get people to give you money anyway.

But self-regulation in Second Life was also plagued by another problem. There wasn’t enough money in the market to make self-regulation worth the trouble—and trust me, effective auditing and financial reporting are a LOT of work. But there was enough money to motivate people who don’t play fair to corrupt any attempts to enforce even the most basic elements of honest financial dealings.

So Second Life’s markets collapsed, and hardly anyone stuck around to clean up their own mess.

Well, now that the real life markets are near collapse, the US government, in particular, seems unwilling to just let kids be kids. They are going to swoop in, kiss and bandage a lot of scraped knees, and maybe even make a few kids sit in the corner for a while. But most of us still have a few questions. Will anyone make the kids who caused the mess clean it up? Will they make sure we have the financial reporting system that will help us all look both ways when we cross the street? And maybe a crossing guard for those who don’t seem to know better.

Then, we can all get a nice afternoon nap, which we will desperately need when this thing crisis is over.