In their book Nicola Gennaioli, professor of finance at Bocconi University, and Andrei Shleifer, professor of economics at Harvard University “A Crisis of Beliefs” give the reader a novel interpretation of the 2008 crisis as well as the tools to understand financial instability on a larger scale. This book is a summary of the authors’ research and it is effective because it gives the possibility to almost everyone to better understand behavioral economics and financial fragility.
The authors develop two important theses in their book: firstly, a detail account of why the classic explanation of the reason behind the crisis was wrong and secondly, they propose a psychological explanation of the crisis based on how agents in financial markets form their expectations.
Now it’s time to understand why the two most important theories pointing out the crisis’ origins are not coherent with the data we have on expectations.
The Moral Hazard Theory
One of the classic explanations is the following: “bankers knew the risks, but they also knew that in case of bank’s bankruptcy the Treasury would save them since they are too big to fail”. This is the so called “moral hazard theory”.
This graph shows that when the bubble collapsed, bankers lost on their real estate investments the same as everyone else and even more. They also lost money because they held a substantial amount of their personal holdings within equity in their respective banks. During the period before the bubble collapsed, everyone, including households as well as bankers and investors, have the same overoptimistic view on both the housing market and on MBS.
The Bank Run Theory
According to this theory the assets of banks were good but are financed by short term liabilities. When the short-term debt investor refused to roll over the loans, financial institutions were forced to sell off their assets. Since everyone was selling the same assets at the same time, this brought incredibly heavy losses, potentially leading to bankruptcy.
The problem with this theory is that it puts the cart before the horse. The horse are the losses and the bank run is the cart. The bank’s assets were rather inflated, the losses on the MBS caused the bank run and not vice versa. This is important because if real solvency problems are present it’s not enough to use liquidity measures to save banks, but capital injections are required.
In the rest of the book, the authors use psychological literature to present models of expectation and belief formation. According to them, these models are pertinent in explaining what happened in 2008 and what happens more generally during any credit cycle.
The belief formation mechanism based on representativeness heuristic and diagnostic expectations, are the psychological foundation of the authors’ model. Citing the first two researchers that developed the concept of representativeness, Daniel Kahneman and Amos Tversky (1972), “an attribute is representative of a class if it is very diagnostic, that is, if the relative frequency of this attribute is much higher in that class than in a relevant reference class.”
To better understand this concept the Irish hair color example is very useful. There is a different survey that shows that when someone is asked which one is the most probable color of hair of an Irishman a lot of respondents say red. Although red hair is more common in Ireland than in other counties of the world only 10% of the Irishman have red hair. People tend to overestimate the percentage of people with red hair inside the Irish population because the attribute “red hair” is a representative attribute of the class “Irish”.
To justify the psychological mechanism behind the 2008 crisis and the credit cycle in general it’s important to introduce diagnostic expectation, the mechanism of belief formation based on representativeness.
When an economic agent reacts to news, both negative and positive, they overreact, and this brings a distorted estimation. The direction of the correction of the expectation is the right one, the error is in the amount.
When they react to good (bad) news it’s common that people in forming their expectations may make two mistakes: overestimate (underestimate) the mean and underestimate (overestimate) the volatility. This brings an inflation (deflation) of assets’ prices and to think that the left tail of the distribution of the return of an asset are too thin (fat) if compared with the reality.
The authors also demonstrate how a model based on diagnostic beliefs is much more than a mechanical explanation of the crisis, since it can describe also different phenomenon like a laboratory puzzle on decision under uncertainty. The authors also conclude their book saying that this is the “first step” in the direction of an integration of the study of beliefs into the current economic analysis, and that there is still a lot to be done in order to obtain a complete and detailed understanding of this complex, yet fascinating phenomena.
I would recommend “A Crisis of Beliefs” to anyone who wants to improve their understanding of the drivers of financial instability and of the potential application of results from psychology to economics.
Both the credit cycle and financial bubble are not a modern phenomena and they are not finished with 2008 crisis, this book helps us understand why bubbles inflate and how they later deflate, which is something we must all keep in mind.
The most impressive aspect of this book is that it leaves you with more questions than answers and with the certainty that behavioral economics will have a crucial role in the economic literature in the years to come.
A Crisis of Beliefs: Investor Psychology and Financial Fragility: Nicola Gennaioli and Andrei Shleifer, Princeton University Press