lies an ever-shifting horde of homeowners, bankers, business owners, unwitting investors -- in short, people

TO BE NOTED: From Knowledge@Wharton:

Hope, Greed and Fear: The Psychology behind the Financial Crisis Published : April 15, 2009 in Knowledge@Wharton

To explain the current economic crisis, the world of finance has a particular lexicon -- including, for example, credit default swaps, mark-to-market and securitized subprime mortgages. Psychologists, on the other hand, might use very different terms: hope, greed and fear.

The language of psychology helps to address the fact that behind every cut-and-dried statistic about falling home prices and other indicators of economic decline, lies an ever-shifting horde of homeowners, bankers, business owners, unwitting investors -- in short, people. And people often pay no heed to fine-tuned economic models by doing things that are not rational, are not in their best interest, and are justified not by numbers -- but by emotion.

"There are spreadsheets and financial statements and models and rules and regulations," said Carolyn Marvin, a professor at the University of Pennsylvania's Annenberg School for Communications. "On the other hand, there are these feelings we have."

Emotion, it can be argued, not only helped to lead America into the current economic crisis but may also be helping to keep it there. At a recent conference called, "Crisis of Confidence: The Recession and the Economy of Fear," sponsored by the University of Pennsylvania's Department of Psychiatry and the Psychoanalytic Center of Philadelphia, an interdisciplinary panel explored the psychological elements behind today's economy.

"Is there a systematic way to think about our feelings when it comes to the economy?" asked Marvin, the panel moderator. The word "confidence" itself has a double edge to it, encompassing optimism on the one hand and delusion on the other. And could there be a psychological tinge to economic vocabulary itself? "The powers that be are avoiding the word 'depression,'" Marvin pointed out, "which describes not only a state of the market but certainly a clinical condition."

Psychological factors are at work behind the crisis, the panel agreed, although each focused on a different element: mania and over-optimism behind the housing bubble, a lack of self-control by consumers hooked on debt, and the shock and feelings of betrayal of many Americans who thought they were making safe investments, but now find themselves facing a frightening and uncertain future.

'An Aspect of Mania'

Like so many others in history, today's economic crisis began with a bubble, according to Wharton finance professor Richard Herring. "Bubbles occur when people are willing to buy something simply because they believe they can sell it for a higher price. [Bubbles] often have an aspect of mania."

Property bubbles are nothing new, said Herring, who presented a chart of home prices during a 400-year period in Herengracht, a canal area in central Amsterdam. Over those centuries, real home prices increased annually by only 0.2% on average, "but in between, [they were] up 100%, down 50%. There was huge volatility."

Real estate booms and busts happen in very long cycles -- on average about every 20 years. Consequently, when housing prices are going up, few remember that they ever went down. This was certainly the case in the recent crisis, since housing prices only went up between 1975 and 2006. According to Herring, property markets are especially prone to booms and busts because of their nature: They have no central clearinghouse of information about prices, transaction costs are high and trading is infrequent, and the supply of property is relatively fixed in the short term. Because the cycles are decades long, it is difficult to tell what a piece of property should be worth in the long run. "We really don't know what the price should be, so it's always difficult to tell whether you are looking at a bubble or simply improving fundamentals of the economy."

Housing booms and busts are "almost always linked to the banking system," Herring added. "When something good happens in an economy, it tends to drive up real estate prices, and banks tend to lend to support that, because people now have collateral." Optimism about rising prices feeds the frenzy, and as an increasing number of novice investors enter the market, prices and enthusiasm also increase. "You get into this upward spiral that can take you a very long way for a very long time. You may ask where the supervisors and regulators are in all of this, and often, they tend to support it. They really like to see loans that are collateralized by real estate because it's tangible."

Call it "the fallacy of misplaced concreteness," Herring quipped, showing a slide of a half-built skyscraper from a recent property boom-gone-bust in Thailand, "but really it's the fallacy of misplaced concrete." Again, emotion plays heavily into the cycle. People suffer "disaster myopia," either because they simply can't imagine a downturn happening, or they assume the probability of it happening is so low that it really isn't worth worrying about, Herring stated.

Ever-rising Home Prices

"I think we agree that over-optimism is perhaps a lot of what got us into this mess," said Wharton business and public policy professor Jeremy Tobacman, a panel participant. "There was rampant over-optimism about housing prices."

Tobacman pointed to a survey by Case and Shiller in 2003 of homeowner attitudes in four major markets -- Boston, Milwaukee, Los Angeles and San Francisco. In all four markets, more than 80% of homeowners surveyed said they believed home prices would rise over the next few years. When homeowners were asked how much they expected the price to change in the next months, mean responses ranged from 7.2% in Boston to 10.5% in Los Angeles.

"Even more astonishing than these one-year numbers are the numbers for decades," Tobacman noted. When faced with the question, "On average over the next 10 years, how much do you expect the value of your property to change each year?" homeowners in Milwaukee said they expected prices to rise by 11.7%. Homeowners in San Francisco said they expected a 15.7% return.

People often make poor economic choices because they are overly optimistic about what they will do in the future, Tobacman said. For example, people transfer credit card balances over to cards with high long-term interest rates because they believe they will pay everything off before the much lower teaser rate expires. (Most don't.) Borrowers who default on payday loans typically pay interest amounting to 90% of the loan's principal before they finally give up and stop making payments.

One study of a health club found that members who worked out on average just four times a month chose to pay a monthly membership fee of $85, even though the gym also offered a pay-as-you-go rate of $10 per visit. "When people are polled about their beliefs [as to] what they're going to do, there is a radical refusal to accept reality," said Tobacman. "Myopia may be willful in that we don't want to contemplate undesired outcomes."

In the recent bubble, both buyers and lenders were overly optimistic about what the future would bring. Buyers ignored the possibility that they might not be able to keep up on payments because they assumed the prices of homes would go up and they would be able to sell or refinance. Likewise, lenders ignored the possibility of default because rising home prices had made it easy to get bad loans off the books. Tobacman shared a quote from John Kenneth Galbraith's The Great Crash, a history of the events leading up to the Great Depression: "The bankers were also a source of encouragement to those who wished to believe in the permanence of the boom. A great many of them abandoned their historic role as the guardians of the nation's fiscal pessimism and enjoyed a brief respite of optimism."

Said Tobacman: "I think the question is, when exactly does this powerful impetus to believe in a rosy future get disciplined by the market and when does it get out of hand?"

The explosion of consumer debt behind the crisis is also an issue of self-control, University of Pennsylvania psychology professor Angela Lee Duckworth noted. "It's a perennial human problem, to delay gratification. We all struggle, from little children to the oldest and wisest, with the problem of self-control."

Duckworth defined self-control as the ability to negotiate a situation in which there are two choices and one is obviously superior, but the other choice is nevertheless more tempting. For example, a dieter faced with a chocolate cake knows that it is best not to eat it, but often makes a choice to eat it anyway. In the case of the housing bubble, homebuyers failed to exercise self-control when they bought larger homes than they knew they could afford. Lenders failed to exercise self-control when they chose to write shaky mortgages in order to bank short-term profits.

For years, Americans have saved less and consumed more, Duckworth said. She pointed to the conclusion of a recent editorial in The Wall Street Journal by Chapman University research associate Steven Gjerstand and Chapman University economics professor and 2002 Nobel Laureate Vernon L. Smith: "A financial crisis that originates in consumer debt, especially in consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge," the editorial stated.

Added Duckworth: "It seems that my father was right during those conversations around the dinner table when he would say, 'Americans are living beyond their means.' I guess we were. And I think that's in part because all human beings want to live beyond their means."

Self-control is an aptitude that changes dramatically over a lifetime, according to Duckworth. This is because the prefrontal cortex, the area of the brain that allows human beings to control impulses and delay gratification, matures more slowly than other parts of the brain. "Sub cortical regions and the brain stem are more or less online as soon as you're born, if not very soon after ... so emotion and impulse in these areas are functioning at full throttle" right away, she said. But the prefrontal cortex is not fully developed until a person is much older -- somewhere in the late 20s and possibly as late as the early 50s.

"There's a lag problem here, where we have our emotions and we have our impulses ... but you have to wait until you're at least 25 before the frontal cortex is in great shape to actually rein in those lower-level desires."

Studies by psychologist Walter Mischel that measure how well a preschool child could delay gratification (asking the child to choose between eating one marshmallow now or getting two later) predicted a range of outcomes that happened later in life, from SAT scores to divorce to use of crack cocaine, Duckworth noted. "I think that these almost unbelievable findings are in fact believable, because Walter Mischel was able to distill in a simple testing situation the classic human dilemma that we all face every day, which is: more later, or a little bit now?"

These and later studies on delayed gratification have shown that self-discipline is a bigger predictor of later success than other factors such as I.Q., Duckworth stated. A better understanding of the psychology of self-control could help "develop government policies that would presumably accommodate the realities of human nature."

A Question of Trust

"What happens when the bubble breaks, as it inevitably does?" Herring asked. The pendulum swings back to the other extreme. "People find it all too easy to imagine that bad things can happen to the market and they withdraw. And they tend to overshoot. They will act very, very risk averse for quite a long time until they are persuaded that [real estate] is once again a safe asset to hold."

According to David M. Sachs, a training and supervision analyst at the Psychoanalytic Center of Philadelphia, the crisis today is not one of confidence, but one of trust. "Abusive financial practices were unchecked by personal moral controls that prohibit individual criminal behavior, as in the case of [Bernard] Madoff, and by complex financial manipulations, as in the case of AIG." The public, expecting to be protected from such abuse, has suffered a trauma of loss similar to that after 9/11. "Normal expectations of what is safe and dependable were abruptly shattered," Sachs noted. "As is typical of post-traumatic states, planning for the future could not be based on old assumptions about what is safe and what is dangerous. A radical reversal of how to be gratified occurred."

People now feel more gratified saving money than spending it, Sachs suggested. They have trouble trusting promises from the government because they feel the government has let them down.

He framed his argument with a fictional patient named Betty Q. Public, a librarian with two teenage children and a husband, John, who had recently lost his job. "She felt betrayed because she and her husband had invested conservatively and were double-crossed by dishonest, greedy businessmen, and now she distrusted the government that had failed to protect them from corporate dishonesty. Not only that, but she had little trust in things turning around soon enough to enable her and her husband to accomplish their previous goals.

"By no means a sophisticated economist, she knew ... that some people had become fantastically wealthy by misusing other people's money -- hers included," Sachs said. "In short, John and Betty had done everything right and were being punished, while the dishonest people were going unpunished."

Helping an individual recover from a traumatic experience provides a useful analogy for understanding how to help the economy recover from its own traumatic experience, Sachs pointed out. The public will need to "hold the perpetrators of the economic disaster responsible and take what actions they can to prevent them from harming the economy again." In addition, the public will have to see proof that government and business leaders can behave responsibly before they will trust them again, he argued.

"Once a person has been traumatized, promises ... are experienced as dangerous -- not safe -- because they require trust to believe," said Sachs. "It is up to the victim to decide when she can trust again. This takes time."

"As was the case in the 1930s, we also have a choice"

Martin Wolf on Keynes on the FT:

"We are all Keynesians now. When Barack Obama takes office he will propose a gigantic fiscal stimulus package. Such packages are being offered by many other governments. Even Germany is being dragged, kicking and screaming, into this race.

The ghost of John Maynard Keynes, the father of macroeconomics, has returned to haunt us. With it has come that of his most interesting disciple, Hyman Minsky. We all now know of the “Minsky moment” – the point at which a financial mania turns into panic.

Like all prophets, Keynes offered ambiguous lessons to his followers. Few still believe in the fiscal fine-tuning that his disciples propounded in the decades after the second world war ( TRUE ). But nobody believes in the monetary targeting proposed by his celebrated intellectual adversary, Milton Friedman, either( TRUE ). Now, 62 years after Keynes’ death, in another era of financial crisis and threatened economic slump, it is easier for us to understand what remains relevant( I SAY USEFUL ) in his teaching.

I see three broad lessons.

The first, which was taken forward by Minsky, is that we should not take the pretensions of financiers seriously. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” Not for him, then, was the notion of “efficient markets”( I AGREE ).

The second lesson is that the economy cannot be analysed in the same way as an individual business. For an individual company, it makes sense to cut costs. If the world tries to do so, it will merely shrink demand( AS A WHOLE, I CAN UNDERSTAND THIS ). An individual may not spend all his income. But the world must do so( TRY TO ).

The third and most important lesson is that one should not treat the economy( ECONOMICS IS FINE HERE ) as a morality tale( HERE I DISAGREE COMPLETELY. MORALITY IS PART OF POLITICAL ECONOMY ). In the 1930s, two opposing ideological visions( THERE WERE OTHERS, THANKFULLY DEFEATED ) were on offer: the Austrian; and the socialist. The Austrians – Ludwig von Mises and Friedrich von Hayek – argued that a purging of the excesses of the 1920s was required. Socialists argued that socialism needed to replace failed capitalism, outright. These views were grounded in alternative secular religions: the former in the view that individual self-seeking behaviour guaranteed a stable economic order(I DON'T AGREE WITH HIM HERE. VON MISES CRITIQUE OF SOCIALISM WAS MORE THAN A MORALITY TALE, AND SO WERE HAYEK'S VIEWS ABOUT THE MARKET AND THE DANGERS OF TOO MUCH STATE CONTROL); the latter in the idea that the identical motivation could lead only( IT WAS THIS MECHANISTIC APPROACH TO POLITICS AND POLITICAL ECONOMY THAT MADE MARXISM, FOR EXAMPLE, NOT SUITABLE FOR HUMAN CONSUMPTION ) to exploitation, instability and crisis.

Keynes’s genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge( WRONG ). He wished to preserve as much liberty as possible( I AGREE. AS DO I. ), while recognising that the minimum state( HERE I DISAGREE ) was unacceptable to a democratic society with an urbanised economy( I CAN FORESEE A TIME OF LESS GOVERNMENT INVOLVEMENT, BUT THIS IS CURRENTLY TRUE ). He wished to preserve a market economy, without believing that laisser faire makes everything for the best in the best of all possible worlds( I WOULD SEEM TO AGREE WITH HIM ).

This same moralistic debate is with us, once again. Contemporary “liquidationists” insist that a collapse would lead to rebirth of a purified economy( COMPLETELY UNBURKEAN ). Their leftwing opponents argue that the era of markets is over. And even I wish to see the punishment of financial alchemists who claimed that ever more debt turns economic lead into gold( I WOULD LIKE TO SEE THE PUNISHMENT OF CRIMINALS ).

Yet Keynes would have insisted that such approaches are foolish. Markets are neither infallible nor dispensable( TRUE. THEY ARE USEFUL. ). They are indeed the underpinnings of a productive economy and individual freedom( TRUE ). But they can also go seriously awry and so must be managed with care( TRUE ). The election of Mr Obama surely reflects a desire for just such pragmatism( TRUE ). Neither Ron Paul, the libertarian, nor Ralph Nader, on the left, got anywhere( TRUE ). So the task for this new administration is to lead the US and the world towards a pragmatic resolution of the global economic crisis we all now confront.( I AGREE )

The urgent task is to return the world economy to health.

The shorter-term challenge is to sustain aggregate demand( YES ), as Keynes would have recommended. Also important will be direct central-bank finance of borrowers( YES ). It is evident that much of the load will fall on the US, largely because the Europeans, Japanese and even the Chinese are too inert, too complacent, or too weak( TOO MUCH BEGGARING ON THEIR PART ALREADY ). Given the correction of household spending under way in the deficit countries( SPENDER COUNTRIES ), this period of high government spending is, alas, likely to last for years( BTREATHE DEEPLY MATE ). At the same time, a big effort must be made to purge the balance sheets of households and the financial system. A debt-for-equity swap is surely going to be necessary( IT WON'T NEARLY BE AS LARGE AS HE THINKS. TOO MANY PEOPLE WANT THE OLD SYSYEM BACK. IT SUITS US. ).

The longer-term challenge is to force a rebalancing of global demand. Deficit( SPENDER ) countries cannot be expected to spend their way into bankruptcy( TRUE ), while surplus ( SAVER )countries condemn as profligacy the spending from which their exporters benefit so much( THAT'S WHY THEY'RE STRUGGLING TO KEEP THIS SYSTEM ). In the necessary attempt to reconstruct the global economic order, on which the new administration must focus, this will be a central issue. It is one Keynes himself had in mind when he put forward his ideas for the postwar monetary system at the Bretton Woods conference in 1944.

No less pragmatic must be the attempt to construct a new system of global financial regulation and an approach to monetary policy that curbs credit booms and asset bubbles( WE'LL TRY ). As Minsky made clear, no permanent answer exists( TRUE ). But recognition of the systemic frailty of a complex financial system would be a good start( OK ).

As was the case in the 1930s, we also have a choice: it is to deal with these challenges co-operatively and pragmatically or let ideological blinkers and selfishness obstruct us ( I AGREE ). The objective is also clear: to preserve an open and at least reasonably stable world economy that offers opportunity to as much of humanity as possible( I AGREE ). We have done a disturbingly poor job of this in recent years. We must do better. We can do so, provided we approach the task in a spirit of humility and pragmatism, shorn of ideological blinker. ( WE GET THE POINT )

As Oscar Wilde might have said, in economics, the truth is rarely pure and never simple. That is, for me, the biggest lesson of this crisis. It is also the one Keynes himself still teaches( I AGREE )."

He gets a bit simplistic, but I generally agree with what he's saying, except for the fact that, long term, I believe that less government with a growing and balanced economy is possible. Keynes view is still too rooted in the 30s to be of major use to us undigested, and is much too pessimistic and mechanistic, as that era tended to be. Again, Political Economy and Politics are underpinned by the context and presuppositions of the time.

What Keynes offers us is a little useful wisdom and a narrative of perceived success at helping the world out of a crisis, which goes a long in times like these.