To What Extent Does Behavioral Economics Explain Mania in Finance?

I say very little, but I’m willing to be convinced. One very implausible, but popular line of reasoning runs along these lines: neoclassical economics assumes every agent is rational and fully informed; the euphoria inflating the real estate bubble was obviously not rational; therefore, neoclassical economics fails to explain the current crisis. Having reached this conclusion, it’s only a short step to the corollary that free markets create catastrophic social consequences.

When Alan Greenspan confessed before a congressional committee that he had revised his assumptions about economics in light of current events, people, notably those on the left, took his mea culpa as the symbolic end of a paradigm. Here at last, in public, a former disciple of Ayn Rand, the prophet in the age of turbulence, had finally announced what all those good gray burghers in coastal college towns long suspected: the science of economics is no science at all. Call off all the bets! Anything goes! In Thomas Kuhn’s notorious phrase, normal economic science is out, revolutionary, paradigm shifting economics is in.

In this vein, Niall Ferguson offers his take on the end of Wall Street:

The problem lay with the assumptions that underlie so much of mathematical finance. In order to construct their models, the quants had to postulate a planet where the inhabitants were omniscient and perfectly rational; where they instantly absorbed all new information and used it to maximize profits; where they never stopped trading; where markets were continuous, frictionless, and completely liquid. 

But this is the weakest part of Ferguson’s analysis. His greatest insight has nothing to do with rationality assumptions. Instead, his strongest arguments about mania rely on a fairly straight forward concept: old motivations coupled with poor design. Behavioral economics was not the first science to identify the vice of stupidity. And neoclassical economics doesn’t assume away incompetence. If the idealism of internet freebooters inflated the dot-com bubble, then likewise it was a version of the American Dream that inflated this one–the property owning society. As Ferguson says: 

There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago.

More interesting to me would be an explanation showing how this generous and confident spirit percolated not just through the financial system, but also through the the populace and their government. In the end I suspect it is less man’s behavioral fallibility that brought us to the brink, but more his good-will.

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