Yale ICF Working Paper No . 12 - 31 Psychology and the Financial Crisis of 2007 - 2008

I discuss some ways in which ideas from psychology may be helpful for thinking about the financial crisis of 2007-2008. I focus on three aspects of the crisis: the surge in house prices in the years leading up to 2006; the large positions in subprime-linked securities that many banks had accumulated by 2007; and the dramatic decline in value of many risky asset classes during the crisis period. I review a number of psychology-based mechanisms, but emphasize two, both of which have already been extensively studied in behavioral finance and behavioral economics: over-extrapolation of past price changes; and belief manipulation. 1 Yale School of Management. This essay is in preparation for Financial Innovation and Crisis (MIT Press, Michael Haliassos, ed.). It is based on an invited talk at a conference in 2009 on the occasion of the awarding of the Deutsche Bank Prize in Financial Economics to Robert Shiller. I am grateful to Malcolm Baker, James Choi, Kent Daniel, Michael Haliassos, Jonathan Ingersoll, Andrew Metrick, and Andrei Shleifer for very helpful comments. The field of behavioral finance investigates whether certain financial phenomena are the result of less than fully rational behavior on the part of some agents in the economy. For guidance on how people deviate from full rationality, it advocates a close reading of research in psychology. The field has focused, with some success, on three areas of application: the pricing of financial assets; the portfolio choice and trading decisions of investors; and the behavior of firm managers. Can behavioral finance offer a useful perspective on the financial crisis of 20072008? In particular, can ideas from psychology help us to make sense of the crisis? I suspect that they can, but it is still too early to be sure. The process of gathering and analyzing data from the crisis period is far from over. Researchers may eventually conclude that psychological factors were important during the crisis; but they may also conclude that they were not of first-order significance. In this short essay, I speculate about some ways in which concepts from psychology may be helpful for understanding the crisis. I do not attempt a comprehensive discussion, but simply sketch a few specific ideas.