Tuesday, October 28, 2008

Behavioral Finance and the Crisis

David Brooks argues that the current financial crisis will be a coming out party for behavioral economics. His starting point is Greenspan's recent confession:
As Alan Greenspan noted in his Congressional testimony last week, he was “shocked” that markets did not work as anticipated. “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”
But this misses a key point. The major players were rational. They made money because they received bonuses based on returns that hid risk. The problem was agency not irrationality. What Greenspan apparently missed is the fact that the managers of corporations do not have interests that coincide with the shareholders. The separation of ownership and control is an old issue in economics. We know that when agency problems arise incentives are need to get the agent to act in the interests of the principal, here the shareholder. To get agents to pursue profits incentive contracts give them shares. But the downside risk is zero -- you cannot indenture as a slave a manager who loses big money. Hence, the manager has big incentives for risk taking. This is what happened.

Now one can argue that the boards of directors or very top managers should have watched risk more closely. But they were booking large profits and large bonuses. Had they believed that markets were efficient they might have wondered how they were earning such large returns -- where are the associated risks that allow this. But instead they assumed markets were inefficient and assumed they had hired wizards. Notice that this is exactly the opposite of the view that Brooks is expressing.

This is not to say that behavioral finance may not have good insights about issues related to the financial crisis (and finance in general, here is a survey), but certainly not in the way argued by Brooks and most commentators today.


donald said...

I recently came across your blog and have been reading along. I thought I would leave my first comment. I don't know what to

say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.



Smith said...

insolvency practitioners

meet. said...

Perrin RowePerrin rowe Perrin Rowe bathroom taps and showers at discount prices from Avalon the Perrin & Rowe specialist.

meet. said...

Fitted kitchens"fitted kitchens Fitted kitchens with FREE kitchen design service. Kitchen units from Pronorm and Wentworth

meet. said...

Fitted kitchens"fitted kitchens Fitted kitchens with FREE kitchen design service. Kitchen units from Pronorm and Wentworth

shriram said...

us citizenship information

meet. said...

kitchen worktopskitchen worktops kitchen worktops at the lwoest UK prices in Corian, Silestone and Granite kitchen worktops. FREE kitchen worktops design service.

rashida said...

Thanks for starting this successful blog. Hopefully over time your authority will grow and you'll be able to impose more influence over other blogs as your successful leadership increases. This will come naturally, don't worry! You won't necessarily be a success from day one but you'll be a leader soon!

saving for kids