It’s a bubble’s effects that are hard to predict

6th June, 2009

One of the benign side effects of the credit crunch has been the boom in popular awareness of behavioural economics – a discipline that brings psychological insights to bear on economic theory. Behavioural economics books, such as Nudge and Predictably Irrational, have sold well and become influential. That is partly because they are good books, but it is also because a superficial reading of both behavioural economics and the credit crunch can lead to the same conclusion: people are crazy.

Yet, while popular awareness of behavioural economics was overdue, the links between irrational behaviour and the credit crunch are more subtle than they first appear. To see this, one need only re-read the behavioural economics books published before the crisis became severe. Nudge has a section on subprime mortgages, but it focuses on consumer protection. Predictably Irrational is being revised in the light of the credit crunch, but the first edition took a similar line, focusing on the vulnerability of naïve consumers. It does not seem to have occurred to the behavioural economists – even after they had seen the first glimmerings of the credit crunch in 2007 – that the banks would need protecting from themselves. The thought did not occur to many other economists, either.

A critical piece of craziness in the credit crunch was the housing bubble in the US, emulated in the UK and around the world. This bubble was spotted and widely advertised by the behavioural economist Robert Shiller, himself the co-author of a new book, Animal Spirits. Several years ago, Shiller had convinced me and many others that the housing boom was a bubble; five years before that, he convinced much the same crowd of people that the dotcom boom was a bubble, too. David Laibson, another behavioural economist, recently gave a keynote lecture at the Royal Economic Society on the subject of “bubble economics”, in which he sketched out some of the psychological underpinnings of bubbles.

The dotcom collapse was a vindication of the theory that we are inherently bubble-prone. Shiller predicted it – and gave plenty of supporting evidence. After that experience, I am surprised that anyone should wonder why the real-estate boom turned sour.

Just as important is how it brought down the world’s financial system. On that point, hindsight is the most powerful tool of all. Traditional schools of thought in economics also have plenty to contribute.

Around the time the behavioural economics boom arrived, I was writing about perverse incentives in big corporations. I explained that when each company’s shares were dispersed among tens of thousands of small shareholders, nobody had a strong incentive to keep an eye on the management. But the managers had an incentive to conceal their compensation in the form of obscure performance contracts that encouraged risk taking, and in the form of pensions and other deferred compensation. The result: large bonuses, excessive risk, outrageous pensions and pay-offs, all while everyone was acting rationally.

I would love to point to this insight and claim that I predicted the credit crunch, but I did not, any more than did the behavioural economists who (rightly) pointed out that consumers were vulnerable to predatory lenders. There is a difference between spotting a problem and predicting that it will corrode the foundations of the world economy. As we try to diagnose the causes of the crisis, cure the condition and vaccinate against a recurrence, behavioural economics has a rightful place in the doctor’s bag. It will not be a panacea; but then nothing ever is.

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