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You get what you pay for: Behavioural economics and the GFC


Suvi Lokuge

By

May 20th, 2017


Although there were many causes of the Global Financial Crisis, it is evident that the irrational behaviour of individuals had a huge role to play.

A major behavioural factor that contributed to the GFC was risk-taking behaviour; both by the employees at financial institutions, and by the general public.

This article first appeared in Short Supply 2017 – check out the full magazine via the Short Supply tab at the top of this page!


Risk-taking behaviour of firms

The failure of Lehman Brothers and Bear Stearns were at the hands of employees who took risks at the expense of the firm. It is true that every asset contains some amount of risk. However, the issue was that employees were never held accountable for the risk of buying and selling ‘toxic assets’ and volatile mortgage backed securities. Wheelan (2010) argues that the mentality of these employees was ‘heads they win, tails the firm loses’. [1] McDonald (2009) argues that it’s the firm’s fault for putting employees on contracts that ‘encourage volume and short term outlook’. [2] These contracts put employees in a position where riskiness was encouraged. Instead, there is a need for contracts that encourage actions that protect the value of the firm, and as a result, the economy.

 

Forecast reliance

Firms basing their actions on inaccurate forecasts led to risk-taking behaviour, ultimately prompting the GFC. The forecasts used by firms were based on mathematical models that ignored the risk of house prices falling. This was despite the fact that house prices fell sharply in the 1980s, and could possibly have been expected to fall again. [3] For example, AIG’s sophisticated risk modelling system had predicted a loss of $180 billion to be impossible. [4] In reality, however, the bank had outstanding insurance on more than $400 billion in securities after the GFC hit. [5]

 

Ignorance

In 2008, at the height of the GFC, it became clear that Wall Street executives knew little about the products they were selling. [6] Merton (2008) argues that ‘management and boards of directors of financial institutions [were] out of their depth, unable to understand new products created by new financial economics’. [7] For instance AIG, the bank that was at the centre of the credit default debacle, sold under-priced insurance on complex, poorly understood securities. [8] This contrasted with the fact that everyone else – regulators, legislators, governments, academics and the general public – assumed that the managers of these banks knew what they were doing, when in fact they did not. [9]

 

Risk-taking behaviour of the general public

The general public’s irrational behaviour is also responsible for the Global Financial Crisis. The use of benchmarking – comparing the rate of return from an asset with a benchmark reference rate – encouraged people to purchase riskier assets. As the public is loss averse, when yield is low there is a search for yield; if the return of the asset is lower than the reference rate, this creates disutility large enough for the public to buy riskier assets to avoid losses. During the period leading up to the GFC, asset returns had been low, which encouraged a search for yield, thereby increasing risk-taking behaviour from the general public. [10]

 

Assumptions

The assumptions that the general public made are partly responsible for their risky decisions. It is human nature to seek out patterns in randomness. For example, 91% of basketball fans believe that a player is more likely to make a shot after making his last two or three, whilst evidence shows this is not the case. [11] It’s normal to assume that what is happening now will continue into the future. In the context of the GFC, people expected that house prices would keep on rising. Based on this assumption, and despite a lack of evidence to support it, people borrowed excessive amounts of money. [12]

Another issue with assumptions was overestimation. Akerlof and Shiller (2009) refer to this as money illusion; overestimating the real value of an increase in house prices. This overestimation of wealth led to people overestimating their ability to borrow and consume, so borrowing and consumption were excessive and possibly outside their means. [13] Akerlof and Shiller (2009) argue that this is part of the reason for a large decline in household savings in the US pre-GFC.

 

Overconfidence

Part of the Global Financial Crisis can be attributed to overconfidence. [14] People chose to cover up deficiencies in a cloud of optimism, instead of coolly considering facts. Everyone knew that the price would eventually fall, as this is part of the bubble process. However, most people thought they could get out before the crash, rating their ability above the average asset holder. This is known as self-serving bias, ‘a tendency to overrate one’s abilities’. [15] It is normal in human nature – for example, 90% of drivers think they have above average driving skills. [16]

 

New era thinking

Akerlof and Shiller (2009) argue that with a boom, comes the optimism of new era stories. New era stories are the tendency to believe that recessions, asset price falls, and volatility were things of the past. [17] It is the idea that we have tamed the business cycle. This new era thinking prompted excessive risk-taking by households. During this period of growth, disagreeing with the new era stories could bring negative labels such as ‘dinosaur’ and ‘pessimist’. However, the GFC has proven to us, time and time again, that we do not have the business cycle figured out.

It is essential to recognise the impact of behavioural factors in the decision-making process; particularly if certain behaviours result in biased decisions with unfavourable outcomes. As part of risk management, behavioural change will be crucial in preventing another financial crisis.

 

Suvi is a third year Bachelor of Economics student majoring in Economics and Econometrics, with a high level of community involvement in social impact and environmental sustainability.

 

[1] Wheelan, C. (2010). Naked Economics: Undressing the Dismal Science. New York, NY: Norton & Company

[2] McDonald, I. M. (2009) The Global Financial Crisis and Behavioural Economics. The Economics Society of Australia Economic Papers, 28(3), 249-254.

[3] Ibid

[4] Johnson, S. (2009). The Quiet Coup. Retrieved from: https://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/307364/

[5] Ibid

[6] Wheelan, C. (2010). Naked Economics: Undressing the Dismal Science. New York, NY: Norton & Company.

[7] Merton, R., (2008). Differing Perspectives on the Credit Crisis. Advisor Perspectives. Retrieved from: https://www.advisorperspectives.com/pdfs/Differing_Perspectives_on_the_Credit_Crisis.pdf

[8] Johnson, S. (2009). The Quiet Coup. Retrieved from: https://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/307364/

[9] Ibid

[10] Corden, W.M. (2008). The World Credit Crisis: Understanding it, and what to do. The World Economy, 32(3), 385-400.

[11] Gilovich, T., Vallone, R., & Tversky, A. (1985). The Hot Hand in Basketball: On the Misperception of Random Sequences. Cognitive Psychology, 24(5), 295-315.

[12] Wheelan, C. (2010). Naked Economics: Undressing the Dismal Science. New York, NY: Norton & Company.

[13] Akerlof, G & Shiller R.J. (2009). Animal Spirits: How Human Psychology Drives the Economy, and why it matters for Global Capitalism. Princeton, NJ: Princeton University Press.

[14] McDonald, I. M. (2009) The Global Financial Crisis and Behavioural Economics. The Economics Society of Australia Economic Papers, 28(3), 249-254.

[15] Ibid

[16] Ibid

[17] Akerlof, G & Shiller R.J. (2009). Animal Spirits: How Human Psychology Drives the Economy, and why it matters for Global Capitalism. Princeton, NJ: Princeton University Press.

Image: ‘That was supposed to be going up, wasn’t it?’ by Rafael Matsunaga, https://flic.kr/p/JmU2w. Licence at http://creativecommons.org/licenses/by/2.0.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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