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The Journal of Socio-Economics 39 (2010) 127–131
Contents lists available at ScienceDirect
The Journal of Socio-Economics
journa l homepage: www.e lsev ier .com/ locate /soceco
he credit crunch: Ideological, psychological and epistemological perspectives
lan Lewisniversity of Bath, Department of Psychology, Claverton Down, Bath BA2 7AY, United Kingdom
r t i c l e i n f o
rticle history:eceived 1 February 2010ccepted 11 February 2010
a b s t r a c t
Two economic interpretations of the credit crunch are outlined and the question posed whether these areincommensurate ideological positions. Psychological perspectives are then explored including insightsfrom cognitive and social psychology. The argument is made that policy options depend on what consti-tutes the ‘good society’ and whether the culture of financial institutions can be changed by government
EL classification:014159
eywords:
intervention, social pressure and human agency. It is concluded that those interested in socio-economicshave a duty to engage with alternative discourses.
© 2010 Elsevier Inc. All rights reserved.
inancial crisissychological aspects
Economic crises are as inevitable as rain in an English summer;et exactly when it is going to rain is irritatingly unpredictable. Thenancial problems of 2008 may have features not seen before butoom and bust cycles have been with us for some time, viz. the tuliprenzy in 17th Century Holland, the South Seas Bubble of the 18thentury and the stock market boom and bust of the 1920s. Thereeems to be a dimming of collective memory, myopia in the face ofistory, where the next cycle takes us completely by surprise.
There is some consensus about the causes of the economic prob-ems of 2008 and beyond. In a nutshell, financial institutions lent
oney they did not have to people who could not pay it back. Tout it more technically, the problem was with ‘leverage’: banks bor-owed money to lend to sub-prime mortgagees producing ‘toxicssets’ as the bubble in the housing market burst and interest ratesent up. With the fall of Lehman Brothers many feared a globalelt-down of financial markets and in September 2008 both theK Chancellor of the Exchequer, Alistair Darling, and the Frenchinance Minister, Christine Lagarde, described it as the worst finan-ial crisis since World War II (BBC ‘The Love of Money’ 2009). Theoss of confidence in the banking world meant action had to beaken. In the US a policy was put to Congress for the state to buyhe toxic assets so that banks could start lending again. With aS election not far away, Republicans in particular were sceptical
nd many voters believed that this form of government interven-ion was a kind of socialism incompatible with their ‘free market’rinciples. The policy was defeated in Congress; consequently thetock markets fell heavily again. The more radical policy of the stateE-mail address: [email protected].
053-5357/$ – see front matter © 2010 Elsevier Inc. All rights reserved.oi:10.1016/j.socec.2010.02.015
becoming the main stockholder of major banks was taken up first bythe Irish government and shortly after by the UK government actingas guarantors for investors. Effectively the US had little choice butto follow suit, or risk vast amounts of money flowing to the UK andIreland. The truly global nature of capital markets has never beforebeen made so starkly apparent. Statements from the G20 summitunderlined the importance of nations making decisions of thesekinds in consultation with one another. Eye-catching statementswere also made about the need to curtail greed and inappropriatebonuses in the financial and banking sectors. Financial legislationshould have sharper teeth so that bankers would not be allowed tomake these kinds of mistakes again. And finally longer-term finan-cial plans need to be put in place to “build an inclusive, green andsustainable recovery” (G20, 2009).
While the French President, Nicolas Sarkozy, in a statement in2008 pronounced that the crisis heralded the end of excessive greedand laissez-faire economics, the French Finance Minister, ChristineLagarde, has been more cautious. She has voiced concerns that therhetoric of the G20 statements may be empty as very little has yetbeen done to control financial excess and she is concerned that the‘old’ culture of financial institutions will return very rapidly as ifnothing had happened at all (BBC, 2009).
1. Two discourses
Rather surprisingly, given extensive sympathy for ‘free market’economics, particularly in the US, the following three part discoursehas become the most common one in 2009, i.e. (1) governmentintervention is essential in order to secure stability in financialmarkets; (2) financial surveillance and financial regulation need
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o be tightened; and (3) key banking actors must be incentivisedifferently in order to avoid short-term profits and excessive greed.
A completely difference discourse is presented in an edited booky Philip Booth (2009), ‘Verdict on the Crash: Causes of Policy Impli-ations.’ Here the thesis is that the financial crash of 2008 was notaused by ‘market failure’, rather it was caused by ‘government fail-re’. The US government in particular, through a process of ‘socialngineering’, must bear considerable blame, it is argued. Driven by aolicy of inclusion and a belief that home ownership provides bothconomic and political stability and a greater chance for poorer peo-le to pursue wealth and happiness led to Fannie Mae and Freddieac, with explicit government targets to provide mortgage finance
o poorer households, taking too many risks. Furthermore, financialegulators have failed to act quickly enough, or in an appropriateay to avert the crisis; they should therefore not be rewarded for
heir inefficiency by having yet more regulatory powers at theirisposal. The authors further argue that serious systemic problemsave not arisen amongst unregulated institutions and that regu-
atory systems encourage complexity and a lack of transparency.erhaps most radical of all is the advocacy that banks should bellowed to fail (albeit in an orderly way).1 This is all reminiscentf Adam Smith’s ‘invisible’ hand where the natural order of thingshould be allowed to return and that bubbles and economic crisesre an integral part of the system; rather like forest fires, whererowth is more vigorous afterwards.
What becomes clear is that economists do not agree with onenother and it is tempting to interpret this as a battle between twoelief systems or ideologies where one group believes that marketshould be left alone to resolve problems naturally as they arise,here the other believes that government intervention is essential
o correct market failure. Most economists see their discipline aseing guided by the tenets of logical positivism and analytic science,central tenet being that analysis should be value free. Yet it is
ifficult to see how these competing claims can be resolved by anyind of empirical test as these belief systems are resistant to change,omprising, in a Kuhnian sense, incommensurate paradigms.
Faced with the crisis, policy makers had to be seen to be ‘doingomething’, and quickly. So which of the two discourses coulde drawn on? The problem with the non-intervention approach,
nvoking the ‘invisible hand’, is that it could easily be seen as ‘doingothing’. Research in sociology concerning ‘moral panics’ (Goode,994) and ‘attribution theory’ in social psychology (Jaspers et al.,983) has convincingly shown that there is a fundamental humaneed to take action, to interpret, understand and blame when aalient event incurs. Politicians know this and had to respond inrder to maintain the support of the electorate. Doing nothingas not an option politically, as Lawrence Summers, Director of
he White House National Economic Council put it at a speech athe Brooking Institution about the crisis: “There is room for debatebout how regulation should be enhanced, but not I suggest abouthether we should stay with the status quo,” (p. 15) and “If my
peech was intended to persuade you of one thing, if you didn’tgree with anything else, it was that this was not a set of economicrocesses that would simply automatically fix themselves if youidn’t act” (p. 37) (Summers, 2009). Politicians and their advisors,cting in their own interests and the political context of sustainingopularity, favoured regulation and the bailing out of banks.
. Individual and cognitive psychology
Much of behavioural economics has been influenced by only oneranch of psychology: cognitive psychology. Cognitive psychology
1 These points are tempered by others which recommend, for instance, enhancedarket disclosures by banks to shareholders.
nomics 39 (2010) 127–131
is dedicated to the study of thinking, reasoning and decision-making. A considerable literature has now built upon cognitivepsychology and financial decision-making. Attention was drawnto the studies not only by the pioneering work of Kahneman andTversky (1979) but by the ‘Anomalies’ series in the Journal of Eco-nomic Perspectives by Richard Thaler (1992). The latter took thebroad view that the assumptions of REM are essentially correct butthat people are prone to persistent heuristic biases which need tobe identified and added to the model in order to make it more inkeeping with the empirical world (for some commentators so manyof these ‘anomalies’ have been identified that it is not clear whatone should do with them all, with the feeling, certainly amongsome economists, that we might just as well return to REM una-mended). In contrast Gigerenzer and Selten (2001) have claimedthat far from heuristic biases being exceptions to rationality, theyconstitute an ‘adaptive toolbox’ which allows people to make fastand frugal decisions, which in our animal past may have increasedsurvival ratios.
Heuristics which may be helpful in one context are unlikely toapply to all and it seems plausible that some may be maladaptivein the context of the financial crisis of 2008 and beyond. The idea isthat everyone is prone to maladaptive thinking, including financialexperts and ‘lay’ people. This may help explain a bubble as a signif-icant number of people making the same errors at the same timeand in the case of ‘herding’ are reassured by the fact that people arebehaving in similar ways.
One aspect of ‘maladaptive thinking’ relevant to the recenthousing bubble is ‘optimum bias’. Moore et al. (1999) reportedan investment experiment with MBA students finding that over-confidence and false optimism are rife when stocks are rising;participants were even optimistically biased about past per-formance. These (and other) findings could be relevant whenunderstanding bubbles—people get over-optimistic and ‘forget’past failures.
The optimism bias is probably caused by an illusion of control,of being better than average. Sutherland (1992) for example hasrecorded that 95% of British drivers think they are better than aver-age. Over-optimistic stock market traders can be less likely to makea profit (Fenton O’Creery et al., 2003). Furthermore when things aregoing well traders tend to attribute success to their own know-howand expertise: when things go badly there is a strong tendencyto blame things that are beyond the traders’ control. This phe-nomenon appears to be widespread and is termed in psychologyas ‘the fundamental attribution error’. These individual tenden-cies are also linked to more social aspects (which will be revisitedlater) such as ‘herding’. Given that over-confidence is widespread,a trader will be perceived by others, including those who makedecisions about bonuses, as behaving conventionally when mak-ing similar decisions to others (although the traders are still likelyto attribute successes to themselves). Being conventional is also adefence when profits fall.
There is also evidence for confirmation bias (Wason andJohnson-Laird, 1972) where when people have an idea in theirheads (and in our case that house prices/stocks will continue torise) people have a strong tendency to look for evidence which con-firms their view, and pay less attention to evidence that does notfit. There is an enormous amount of financial data which is readilyavailable and it can be manipulated, to some extent to support anumber of quite contradictory hypotheses.
The money illusion has also probably made things worse as thereis a tendency for people only to consider nominal values. In this case
the profits that people expected from house sales were unrealisti-cally high as inflation tends to be underestimated. Also all houseprices of course were rising for most people; even after a sale youstill need to buy another house. The money illusion also makesmortgage loans more attractive.
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. Social influences
‘Groupthink’ (Janis, 1982) is a kind of over-confidence at aocial level which can lead to disaster. Janis has characterised thentecedents of ‘groupthink’ as excessive group cohesiveness, ide-logical homogeneity and high stress. The symptoms compriseeelings of invulnerability and a tendency to discredit informa-ion at odds with the unanimity of the group. According to Janishese tendencies result in poor decision-making and he has usedhem to interpret the 1961 Bay of Pigs fiasco and the 1941efence of Pearl Harbour; it is also a useful interpretation of highlytressed and closed-minded financial institutions competing withne another in a booming market where principal agents becomeeaf to news, or warnings that do not fit the powerfully prevail-
ng group view. There is a strong tendency for groups (includingnancial experts) to develop a collective ‘wisdom’ which is hard tohake.
When large numbers of people believe in the same things, forxample that house prices will continue to rise, has been calledhe ‘bandwagon effect’ (Leibenstein, 1950; De Bondt and Forbes,999). Information signals become homogenised in the investmentommunity (and elsewhere) and ways of thinking become sociallynd professionally shared.
There are a whole host of overlapping theories and approacheshich are relevant including social influence (Festinger, 1954),
ocial learning (Bandura, 1977) and social dependence. What allhese approaches have in common is the belief that decisions ofll kinds, including financial decisions, are rarely (and perhapsever) made in isolation. We continually look to others for informa-ion and verification. These social influences become so powerfuluring bubbles that the ‘madness of crowds’ (and the promise ofuge financial gains) can dupe even extremely clever people. Sir
saac Newton lost a huge sum when the South Sea Bubble burstSchachter et al., 1986). It could be wrong, however, to suggesthat contemporary social psychology unequivocally adheres to themadness of crowds’ thesis. The classic work of Le Bon (1908) basedn descriptions of the crowds during the 19th Century French revo-ution does indeed describe how when part of an organised crowdman descends several rungs on the ladder of civilisation . . .. heay be a cultivated individual; in a crowd he is a barbarian . . .. a
reature acting by instinct” (p. 12). Attempting to maximise utilityn the form of wealth is probably one such basic instinct. Le Bon
rites that in such situations people lose personal responsibilityor their actions; ideas spread rapidly through a process of conta-ion. However, Reicher (1984) and Reicher and Potter (1985) showhat crowds can be orderly and engender a positive social identitynd that rather than talking about losing identity and responsibil-ty it is better to think about ‘changes’ of awareness and behaviour.t should also be stressed that much of ‘traditional social psychol-gy’ stresses that groups are bad for you (e.g. Zimbardo’s Stanfordrison experiment) but groups can be good for you too, providingsense of belonging as well as allowing, in some instances at least,
uperior decisions to be made than those made individually. In atudy by Treynor (1987) participants had to guess, on their own,ow many jelly beans were in a jar (there were 850). The aggregatenswer was 871 where only one of the participants (there were 56f them) did better.
‘Herding’ is a similar concept used in the behavioural financeiterature. When herding occurs people follow the choices made bythers independently from their private information. Also devia-ion from others may incur reputational costs: according to Hong
t al. (2000) younger portfolio managers are less likely to devi-te from the consensus compared to older ones as their reputationas yet to be made. In an experiment by Cote and Sanders (1997)articipants were asked to predict future returns individually. Sub-equently they were supplied with the average predictions of thenomics 39 (2010) 127–131 129
participants. Participants soon followed the crowd, especially whenreputational motivation was highly pertinent.
4. Psychology used by economists
In his book ‘The sub-prime solution’ Robert Shiller mentions‘Psychology’ quite a few times yet cites very few studies andhas chosen not to go into any depth (Shiller, 2008). He consid-ers that there is a ‘psychological’ belief that house prices ‘ought’to go up, partly based on something like a 14 year run of houseprice increases in the US. He then draws on sociology (and, to anextent, on narrative and discursive psychology, without saying so)in describing the ‘new era’ of self-reinforcing stories which sus-tain ‘irrational exuberance’, the stories themselves becoming partof a social contagion legitimised by the press and financial expertswhich are rarely analysed or questioned. ‘Psychology’ appears againin a persuasive paragraph on page 47: “Psychological, epidemio-logical and economic theory all point to an environment in whichfeedback of enthusiasm for speculative assets, or feedback of priceincreases into further price increases, can be expected to producespeculative bubbles from time to time.”
Akerlof and Shiller (2009) mention the importance of the moneyillusion, Keynesian ‘Animal Spirits’ and the role of ‘confidence’ (orlack of it) in modern macroeconomics. They also reintroduce theconcept of morality to economic thinking as they argue that “thebusiness cycle is connected to fluctuations in personal commitmentto principles of good behaviour and to fluctuations in predatoryactivity, which in turn is related to changes in opportunities forsuch activity.” (p. 38). There is a recognition that unprincipled pur-suit of profit can arise when opportunities present themselves,when punishments and disincentives are not in evidence and where‘everybody else is doing it.’ In addition to this there are culturalshifts in ‘animal spirits’ where unbridled pursuit of self-interestand aggressively competitive predatory activities compete withco-operative behaviour as the dominant norm. Akerlof and Shillerconclude: “Because these cultural changes are difficult to quantify,and fall outside the field of economics, they are rarely connectedby economists to economic fluctuations. They should be.” (p. 39).
Rapp (2009), drawing heavily on the work of Galbraith (whichlinks to the mass hysteria model of crowd behaviours, e.g. Le Bon,1908) asserts that “It is impractical to attempt to outlaw mass finan-cial euphoria that seems to be imbedded in the human psyche.”The underlying assumption is that individuals thinking alone aremore intelligent than groups. Greed means we have short memo-ries and ignore history. Momentum buying is generated by greedwhich ignores the original stimulus for the boom, where real valuebecomes irrelevant.
That economists should want to include aspects of psychol-ogy in their writings is welcome news to psychologists, who havebeen pressing for this for quite some time. Consistent findingsfrom experimental studies in cognitive psychology may well beof considerable use in microeconomics. The more broad-brushapproach of macroeconomics (including speculations about thecredit crunch) draws more commonly, and rather loosely in com-parison, from approaches in social psychology and sociology. Inaddition some economists, notably Keynes and Galbraith, makebold claims about human motives and the human condition fromwhich most psychologists would shy away. For this liaison to con-tinue to be productive there is a case for attempting to identifyempirically and quantify ‘animal spirits’ and, more generally, the
epistemological status of these assertions. Akerlof and Shiller’sidea that there are cultural shifts between periods where unfet-tered self-interest dominates over co-operative behaviour and viceversa recommends that ‘animal spirits’ are not fixed like biologi-cal instincts. It also suggests that we need not always be enslaved
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y our ‘irrational exuberances’. In a light-hearted fashion Akerlofnd Shiller use the popularity of poker over contract bridge as aroxy for recent cultural shifts. Something more tangible would beossible like tracing charitable giving or changes in attitudes andalues measured by international social surveys over time (Jonest al., 1998).
. The good society, culture and human agency
One way of elaborating on Akerlof and Shiller’s note on culturalhifts is to consider two versions of the ‘good society’. The firstersion, perhaps the dominant one, can be summarised by the listf features below:
A belief that individuals, acting alone and following their ownself-interest, in the world of finance and elsewhere, provide ben-efits for society. Government ‘intervention’ should be kept to aminimum and, in the ideal world, removed altogether.‘Rational Economic Man’ is a pretty accurate depiction of humannature which should inform policy.The sole responsibility of business is to maximise profits forshareholders.Materialism, egoism and the pursuit of wealth are laudable per-sonal values which lead to happiness.
The second version of the good society can be depicted as fol-ows:
The government should act as a ‘benevolent dictator’, correctingmarket failure.Alternative models of man, including the recognition of implicitas well as explicit motivations, should inform policy.Business should be socially responsible.Post-materialism, concern for others and the pursuit of wellbeingare laudable personal values which lead to happiness.
It would be foolish perhaps to believe that only the first orhe second version should dominate exclusively as some kind ofalance needs to be struck between them, e.g. the pursuit of self-
nterest may be essential for the working of efficient markets butot when self-interest mutates into unbridled greed. Neither isociety homogenous: it would not do if everyone was a wealth max-miser as we need people in the caring professions, in health andducation as well. However there is an argument that too muchmphasis has been placed on the first model in recent years at thexpense of the second and that predominance of the first model isartly to blame for the current crisis.
Within financial institutions the first model is pervasive ands underpinned by traditionally masculine and conservative valueystems. New recruits have to learn the language and accept theulture quickly if they are to survive (Juravle and Lewis, 2009).or Guyatt (2008, 2009), when considering institutional investors,here are three characteristics of organisational culture which arenhelpful, namely lack of social responsibility, short-termism andonventional thinking. There is some evidence that socially respon-ible investing (SRI) is growing due to changes in preferences andalue systems, the influence of market innovators and a degreef pushing from governments (Lewis, 2002). It is still a minoritynterest. Where there are socially responsible experts ‘in-house’hey are usually involved in supplying information to those who
nally make the relevant decisions (who are less likely to be sym-athetic to these ‘intangible’ concerns themselves) (Juravle andewis, 2008; Lewis and Juravle, in press). Most fund managers havehort-term horizons and are remunerated accordingly. This worksgainst SRI which is best suited to longer-term returns. Actors arenomics 39 (2010) 127–131
unwilling to be out of step with others who are ‘trading’ ratherthan ‘investing’. These are also governed by long-held cultural andsocial expectations and conventions, which include how financialmarkets work, the convention of reviewing fund manager perfor-mance over short periods and concentrating on ‘tangible’ financialcriteria (SRI criteria are viewed as ‘intangible’). Juravle and Lewis(2008) have followed up Guyatt’s research, revealing that there areimpediments to change at individual, organisational and institu-tional levels.
Some hope comes in the form of human agency and the roleof SRI ‘champions’ (Juravle and Lewis, 2009; Lewis and Juravle, inpress). These champions recognise that SRI faces powerful imped-iments as, for instance, SRI is considered to be unconventionaland when SRI out-performs conventional funds the establishmenttends to deride them. One interviewee made it plain that somemainstream fund managers think of SRI advocates as ‘love-in,bearded, sandal-wearing, tree-hugging and teetotal vegetarians’.However, there have been some successes in introducing 3-yearrolling performance indicators to combat short-termism. SRI advo-cates have learned to share the narratives and language of theCity and have fought their corner arguing that SRI is ‘material’rather than ‘immaterial’, ‘financial’ rather than ‘extra-financial’.Their acceptance has been aided by EU trading schemes whichprice externalities; the UN Principles for Responsible Investment,the Carbon Disclosure Project and the Enhanced Analytics Initia-tive. In short they have succeeded not by trying to make financialinstitutions more moral but by making the case for SRI in a languagethat can be understood.
6. Conclusions and speculations
How the credit crunch came about and what to do about it is con-tested within the discipline of economics. Two camps have beenidentified: one which supports the current policy of government‘intervention’ and the second which (with caveats) believes thatbanks should have been allowed to fail. While the discipline of eco-nomics prides itself in its adherence to positivism, the case is madethat the two positions are ideologically driven. Furthermore it is dif-ficult to imagine any empirical test which would help in choosingbetween these competing schools of economic thought.
Socio-economics would do well to recognise that these debatesare not purely technical matters where it can be demonstratedwhich interpretation is correct and which is not. Drawing fromThe Sociology of Scientific Knowledge literature (Mulkay, 1985)it is more useful to view the pursuit of scientific progress as acontinuing battle between advocates, in the press, in books andscientific journals, conferences or wherever debates take place.The prize is to gain the upper hand where the legitimacy ofthe favoured explanation becomes difficult to challenge, or bet-ter still becomes culturally embedded and implicit. There is nostatic technical matrix to be filled in whether it is research in main-stream economics, behavioural, social or experimental economics.Socio-economics should embrace the notion that knowledge iscontinually contested and there is merit in analysing competingdiscourses and the claims that are made.
Some of the psychological perspectives drawn on in this paperare not ideologically neutral either as it has been advocated thatmorals and values are central to any comprehensive interpretationof the credit crunch and policies to alleviate it. These morals and val-ues have been considered on two levels: the level of society, and the
specific culture of financial institutions. It has been argued, in thetwo versions of the ‘good society’, that a balance needs to be struckbetween the two but that in recent times too much emphasis hasbeen placed on naked self-interest and wealth maximisation at theexpense of social responsibility. This view is repeated in the context
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f the culture of financial institutions, where long-term incentivesre recommended and conventional thinking challenged.
As this article goes to press Lord Myers, The U.K.’s City Ministers calling for the major banks to curb salaries and bonuses. In the.K. around £74 billion of taxpayers money has been used to propp the banks yet just 1 year after the near collapse of the financialystem at least 5000 bankers will be paid more than a £1 millionn bonuses and salaries in 2009/10 (The Daily Telegraph, 2009a).he French Finance Minister, Christine Lagarde has so far proven toe right in her prediction that the excesses of financial institutionsnd the arrogance of bankers will quickly return (BBC, 2009).
How can change be achieved? In Britain the Financial Servicesuthority (FSA) has announced that it plans to ban large cashonuses for bank employees. The FSA recommends that where
arge profits are made they should be used instead to build upapital (Daily Telegraph, 2009b). ‘Let’s stop teaching greed’ in busi-ess schools has become a clarion call (Cory and Lynne, 2009).n a more temperate note Rötheli (2009) has argued that gov-rnment intervention should lead to greater transparency, thatnancial analysts need to be trained differently, including training
n ‘bubble-detection’, encouraging a ‘safety culture’, rather than aigh risk, short-term gain culture.
It is plausible that improvements can be made through edu-ation, training and government intervention of various kinds butnancial institutions must be encouraged to change themselves.his may require sympathy and action from senior managementut it also provides an opportunity for individual agency, espe-ially those in socially responsible investment teams. The interplayetween individual self-identity and social-structural factors isomplex (Giddens, 1991) yet the credit crunch has given peo-le the opportunity to re-evaluate themselves. If inappropriateelf-interest is legitimised by the society around one it becomesatural to behave in such a way. It follows that if these motivesecome questioned in the media, in talk and in social practices,he emergence of alternative selves may be possible. It should behe responsibility of all of us, whether it be in policy discussions orcademic work, to keep alternative discourses of the ‘good society’live.
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