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The EVE Online Real Estate Crisis

Back in 2003 when I was helping CCP with their new economy in EVE Online, the biggest problem with their design was that the factories that were central to the player based economy were too cheap to buy and maintain. Since the game was released in the UK a day earlier than in the USA, by the time I was allowed to log into the retail version of the game all of the prime factories had been grabbed. This forced me to race to Minmatar space, where the ships were generally held in lower esteem by beta testers.

There I managed to buy the factories in a key star hub and set up shop. I produced the first Mammoths (a massive transport ship critical to trade) in the game, and also the first Minmatar battleships. I would have loved to expand my production but within days of the retail launch all factories had been bought up and idled by speculators who were charging $300 to $400 per factory, without any way of knowing if they really owned the factory or not.

One week after the launch of EVE I handed a report to Reynir Hardarson explaining, among other things, how this weakness in the economic design threatened their game and how to solve it. My solution was to greatly raise the rents on these factories so that only those that were actually actively running them would want to hold them. The idea was to create a “hot potato” effect where no rational person would want these factories unless they were doing a lot of output with them.

While it took several months to implement the fix, once it was in it worked perfectly by causing the speculators to abandon their stranglehold on the economy. In the meantime a handful of players who did have factories (myself included) got exceedingly rich. Thus the effect of this speculation was increased wealth stratification, reduced economic competition, increased consumer goods prices, and crazy real estate inflation.

Parallels in the “Real” Economy

When I began creating virtual economic systems and theories in 2005, I looked to the way our “real” economies were designed to see if I could find parallel systems. I wondered if excessively low property taxes would do the same thing in real life. The way this works is that if the tax or overhead on property is lower than the rate of increase of the value of that property, then this becomes an investment that generates profit. If the tax on property exceeds the value generated by appreciation, then this becomes a losing investment.

Because of this interaction, high property taxes reduce the value of property, again due to the “hot potato” effect. Low property taxes raise the value of property and trigger speculation. In a “high tax” environment, only those that really need the property will be motivated to hold it. Families would be a good example of a group that “needs” property, some place to live. In a low tax environment, speculation makes property values so high that people seeking homes have a hard time affording them.

I wanted to see how this translated to the real world so I looked around for examples. The most obvious such example was California's Proposition 13, which was passed in 1978 when I was only 12 years old. This not only lowered property taxes, but also increased property values as described above. Its effects were exactly what you would have predicted from the scenario generated in EVE Online.

There was one additional difference in the real world, however. EVE Online is not a closed system. By this I mean that when a tax or rent is paid in EVE, this does not cycle back into the economy, it just magically disappears. In the real world, when a property tax is paid it cycles back into the economy through expenditures on public infrastructure such as education and road maintenance. Thus when the property taxes were lowered the result was a widespread degradation in public infrastructure, an effect not observed in EVE.

Real Estate Bubbles are Pyramid Schemes

When you speculate on real estate, you are gambling that the value of that real estate will continue to rise, at a rate greater than the overhead on that property. This does not occur unless the number of speculators increases over time, otherwise demand would stay flat and property values would not rise. A rapid influx of new residents in California would have also increased property values by increasing demand, but the population growth during this time was relatively flat in California.

A rapid increase in the pool of speculators allows each generation of speculators to unload their investments on the next generation and to generate a profit. Like all pyramid schemes, the system is unsustainable as it would need to approach infinity to continue. The faster the pyramid grows, the greater the profits for the early entrants, and the greater the losses for the last generation of participants (before the crash).

This pattern of real estate speculation in California is a basic part of life there. When a new “bubble” (this is what we like to call the pyramid in California) is forming you get a pattern like this: http://firsttuesdayjournal.com/the-rises-and-declines-of-real-estate-licensees/

Note the huge rise in real estate agents as the bubble heats up and approaches detonation. But this bubble was different. In 2006 I noted the proliferation of the Adjustable Rate Mortgage (ARM). Its use was increasing at a rate that was positively non-linear. The ARM is designed to let new players enter the pyramid that normally would not have the means to do so. This allows the pyramid to go on longer than it normally would, increasing the profits of early entrants. It also ensures that the last generation will be historically large.

Not only was the last generation of this pyramid unprecedented in size, but also in quality. These participants had little or no assets to give up when they got left holding overvalued property at the time the bubble burst. This means that the banks, who were seeking to profit off of the use of ARM's to foreclose on valuable California real estate, ended up with a massive amount of real estate that was not as valuable as they had hoped. It was “under water”. This further drove down property values, creating a negative feedback loop.

The result, which I predicted in 2006 in a conversation (and bet) with a friend who was a retired but powerful financial expert, was a system collapse that threatened to force our banking system to fail. This forces the government to step in to shore up the collapse. What is happening here is that the banks, the instigators of the ARM, did not realize that if the pyramid got too large they would end up being the last generation of the pyramid. Because the government feared what would happen if the banks collapsed, the government stepped in and volunteered to be the last generation of the pyramid.

You might find it interesting to note that I won that bet in 2008 by mutual agreement, and my friend fronted me the money I needed to return to school to study “real” economics. Now I consult to three international gaming companies with net revenues in excess of $1B each, as an applied virtual economist. Thank you CCP and EVE Online for teaching me so much.