THE GENESIS OF THE FINANCIAL CRISIS: GREED AND REPRESSION

A handful of psychological phenomena paved the way for the financial crisis. A more aggressive market regulation is important

By Dieter Frey and Andreas Lenz

[This article published in: sueddeutsche.de 1/4/2009 is translated from the German on the World Wide Web, www.sueddeutsche.de/finanzen/585/453277/text/print.html. Dieter Frey is a professor psychology in Munich. Andreas Lenz is a student in Munich who is writing his thesis on the financial crisis.]

Now it cannot be prevented any more. The greatest financial crisis since 1929 spreads with full rage to the real economy. False incentive systems, poor transparency and inadequate framing structures could lead to catastrophe because of hidden fundamental psychological phenomena. From the perspective of behavioral sciences, these phenomena include:

1. Pursuit of Profit

The striving for massive profit marks most actors. On one side, clients want to invest their money as profitably as possible. This motive seduces them to ignore risks. On the other side, some groups engage in financial transactions and juggle with billions. This promotes greed for the highest possible bonuses and fraud through highly speculative businesses.

2. Short-Term Thinking

The hedonist principle of profit maximization is connected with short-term fixation. When successes appear too quickly, people feel encouraged or confirmed. In the whole market system, quarterly-thinking is triumphantly destructive to the burden of people, natural resources and the environment.

3. Learning Theory and Nonchalance

One principle of psychological learning theories – behavioral patterns that seem rewarding – is repeated. If the rewards are continuous, one increases the risk to gain even greater rewards. If decisions are without negative consequences, the actors develop a monopoly hypothesis: everything will be good in the future. This nonchalance or carelessness can become success arrogance. One deems oneself immune to negative consequences. This reduces the ability and motivation to notice danger signals and also strengthens the illusion that one can successfully take countermeasures or steer against negative consequences. The setbacks need not lead to a revision of the decision. The opposite can occur. One increases the risk and puts everything on one card to reduce the arising loss through possible profits.

4. Herd Instinct

People compare themselves with others. Many saw how others gained massive profits in very inscrutable and potentially high-risk transactions – and that they themselves would be “the dumb” if they didn’t join in. If one does not run along in the mainstream, status, prestige and self-worth would be threatened. The pressing of clients to post great profits is enormous. The competitor with the most sales naturally serves as the standard for one’s own results.

The next page focuses on group thinking, pluralistic ignorance and repression of feelings of incompetence.

5. Group Thinking

The actors in the involved institutions (investment bankers, stock exchange overseers and central banks) did not act as individuals. Decisions including mistakes or wrong decisions were very often made in groups. But group processes have the characteristic that an informal group pressure enjoins conformity and stifles unconventional critical thinking. Whoever sees danger signals adjusts to the pressure of the group and the necessity of acting resolutely and uniformly. The group pretends to be its own truth and holds itself to be non-appealable. The “stars” of the group develop into gurus who are convinced they can force others to their rules of the game, in politics for example.

6. Responsibility Diffusion and Pluralistic Ignorance

The more institutions and persons share in decisions (investment banks, stock exchange oversight, central banks and authorities of different countries), the more responsibility is shared until ultimately no one feels responsible and no institution accepts the necessity of strengthened regulation. That there were hardly negative repercussions for years led to a pluralistic ignorance toward risk. That everyone swam along in the same stream and nothing happened despite the potential risk led to risk becoming innocuous.

7. Repression and Feelings of Incompetence

Investment bankers, sellers, advisors and clients in no way understood why they acted as they did. Only a few had the civil courage and self-confidence to question the status quo. As long as products could be sold and high profits realized, experts and laity tended to leave themselves open and repress. They confirmed one another and repressed feelings of incompetence.

It would be presumptuous to say how immoral the actors were. The so-called market where nothing was regulated and there was no control and no responsibility for results made all this possible. Those who now hastily throw stones because actors sinned against the next generation and are partly responsible for a great economic crisis should ask how they acted themselves as small investors. That hardly one of the actors accepts personal responsibility is psychologically a fatal message. The next misuse scenarios that will be different and have different centers of gravity are already pre-programmed.

Every individual must know what is morally defensible (and about ethical principles and responsible conduct thanks to instruction in schools, universities and MBA programs). However the following also seems important in view of human fallibility: Politics and society must formulate clear rules of the game and set framing conditions for a rational economy and responsible relations with the resources of humankind and the environment.

Often we need Sputnik-shocks, Chernobyl-catastrophes or financial crises before real improvements in transparency and control are implemented. Seen this way, the game at the edge of the abyss can be salutary and lead to a new, coordinated and global financial order.