to judge others’ changing thinking, their understandings, their intentions, their pretenses. It is a judgment faculty

TO BE NOTED: From the NY Times:

"It Pays to Understand the Mind-Set

By ROBERT J. SHILLER

IN 1934, the journalist Johannes Steel wrote a remarkably prescient book, “The Second World War,” which described the social psychology that laid the groundwork for global tragedy.

Mr. Steel was trying to peer into people’s minds and infer their actual world views and motivations — in part by examining prewar cycles of social provocation in Germany and Japan and Italy. His timing about the war was wrong — he expected it to start in 1935, not 1939 — but he was correct about many fundamentals. Yet his early readers were often skeptical and blithely assumed that there would be no war.

So it has been with more recent analyses, based in large part on social psychology, foreshadowing the global economic crisis of the current day. No one got it exactly right, but the insights of the approach exemplified by Mr. Steel and used by some analysts today are worth taking very seriously.

Rather than depending exclusively on quantitative analysis, this method relies on a “theory of mind” — defined by cognitive scientists as humans’ innate ability, evolved over millions of years, to judge others’ changing thinking, their understandings, their intentions, their pretenses. It is a judgment faculty, quite different from our quantitative faculties.

In October 1989, I attended a conference at the National Bureau of Economic Research organized by Martin Feldstein, the Harvard economist, on “The Risk of Economic Crisis.” The conference still sticks in my mind because of a paper delivered there by Lawrence H. Summers, now the head of the president’s National Economic Council and the dominant economic intellectual at the White House. During the Clinton administration, Mr. Summers was Treasury secretary and backed legislation that helped deregulate financial markets; many analysts say the policies helped lay the foundation of the subsequent financial crisis. But back in 1989, because of his imaginative work, I came away with a recognition that a severe contraction, even a depression, could indeed come again.

(His and other papers from the conference are at www.nber.org/chapters/c6231.pdf.)

Mr. Summers told a fictional but vivid story of a big financial crisis, complete with examples of specific events and how people might react to them. Seeing it concretized as an imaginary history, and placed in the near future — in just two years, in 1991 — made it seem more real and familiar.

He said that this crisis would be preceded by an enormous stock market boom, bringing the Dow to the unimagined high of 5,400 by October 1991. (The Dow was at 2,600 on the day of the conference; 5,400 would be 13,000 today if scaled up in proportion to gross domestic product.)

Euphoria gripped the investors of his fictional universe. “The notion that recessions were a thing of the past took hold,” Mr. Summers said. He added that over a 15-year period through 1990 — a time that included the 1987 crash — investors earned an average real return of 11 percent. The popular view was that “with a reduced cyclical element, the future would be even brighter.”

Furthermore, he said, “lawyers and dentists explained to one another that investing without margin was a mistake, since using margin enabled one to double one’s return, and the risks were small given that one could always sell out if it looked like the market would decline.”

Today, this sounds like a description of thinking that led to the 2000s boom, although the leveraging of investments tended to take a form other than that of traditional margin credit on stock purchases.

His fictional account went on to describe the early signs of the crisis, “In October 1991, problems began to surface,” he said, adding that a “major Wall Street firm was forced to merge with another after a poorly supervised trader lost $500 million by failing to properly hedge a complex position in the newly developed foreign-mortgage-backed-securities market.” He went on to describe how this provocation led to a change in psychology and a market crash and problems in banks and credit markets.

His fiction concluded, “The result was the worst recession since the Depression.”

How did he write a story 20 years ago that sounds so much like what we are experiencing now? It seems that he was looking at factors of human psychology, much as Mr. Steel did. Mr. Summers evidently knew that an event like our current crisis was waiting to happen, someday.

Ultimately, the record bubbles in the stock market after 1994 and the housing market after 2000 were responsible for the crisis we are in now. And these bubbles were in turn driven by a view of the world born of complacency about crises, driven by views about the real source of economic wealth, the efficiency of markets and the importance of speculation in our lives. It was these mental processes that pushed the economy beyond its limits, and that had to be understood to see the reasons for the crisis.

Of course, forecasts based on a theory of mind are subject to egregious error. They cannot accurately predict the future. But the uncomfortable truth has to be that such forecasts need to be respected alongside econometric forecasts, which cannot reliably predict the future, either.

Still, in our current crisis, we need to try to understand the perils we face. The motivation for a vigorous economic recovery program must come, at least in part, from our forecasts of the dangers ahead. The greatest risk is that appropriate stimulus will be derailed by doubters who still do not appreciate the true condition of our economy.

Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC."