HUMAN BEHAVIOUR AND FINANCIAL CRISES
Every time we witness a financial crisis, which can be considered to be any of a broad variety of situations (e.g. stock boom crashes) in which some financial assets suddenly lose a large part of their nominal value, we seem overwhelmed. The most experienced investors, economic forecasters and regulators are caught off-guard when financial crises occur. A closer look at past history (19th and 20th centuries) reveals that financial crises are nothing new to mankind as it is indeed documented that the first financial crisis goes back to as far as 1825 (Neal, 1998). In the decades that followed this, there have been other numerous financial crises, which is quite unfortunate so to say. It goes without saying that many financial crises have been associated with banking panics, and many recessions coincided with these panics. Against this backdrop, many economists and financial analysts have offered theories about how financial crises develop and how they could be prevented. Most market participants believe that:
- Easy money (low interest rates and loose credit conditions).
- Inadequacy or poor implementation of proper regulations.
- Greedy financial speculators (bankers and hedge fund managers).
amongst several other reasons, lie at the heart of the problem. There isn’t a doubt that all this form a proximate basis, because there are countries that have taken measures against each and every one of the above reasons and yet they still experience financial crises. This article aims at highlighting the ultimate cause of financial crises with Human Behaviour being the only common de-nominator financial analysts and economists need to consider. Human behaviour offers the best and most comprehensive explanation for recurring financial crises and volatile price movements. This entails both good news and bad news. The good news is that, once we form a deep understanding of our own psyche, we should be slightly more successful in spotting impending crises. As for the bad news, for as long as we be-have humanly, we will never have a cri-sis-free world. This basically means that reducing the frequency and severity of the financial crises is the most we can ever hope for.
“The idea was that humans ... act completely rationally and follow the principle of maximising utility,”
This led to a series of debt defaults across the region. This was followed by the Baring Crisis which started in 1890 which was the worst crisis the developed countries suffered, this was after the Barings brothers (a leading London merchant bank at the time, which was heavily exposed to Argentine debt, be-came insolvent. Then came the Panic of 1907 which started in the US after the stock market fell close to 40% from its peak (end-1906). The panic hit France, Italy, Denmark, Sweden and Japan. Subsequently, there came the crisis at the end of the World War I (WWI) which, reflected the attempts by central banks around the world to unwind the inflation that had been built up during the world war. The Great-Depression occurred in the 1920s. The Latin American Debt Crisis occurred in 1982, and then the Nordic Financial Crisis triggered by the breakdown of the Soviet Empire. The most recent financial crisis is the 2007-2008 financial crisis, that began in 2007 with a crisis in the subprime mort-gage market in the US, and developed into a full blown international banking crisis. This crisis led to the near-collapse of the American international Group.
With this brief history, it is clear that collapse in asset prices and financial crises occur quite regularly and mostly have devastating macro-economic consequences for the countries involved. Mil-lions of jobs are lost; billions of dollars worth of wealth is wiped out within a short period of time when financial crises occur. Forming a sound understanding of their underlying causes is of utmost importance to investors, policy-makers and all other stakeholders. In this article, the ultimate cause being considered is human behaviour.
A step by step look at how human behaviour influences the occurrence of financial crises.
NOTE: Shift from homo economicus to homo sapiens
Throughout most of the second half of the 20th century the efficient market hypothesis (EMH) was broadly accepted by economists.
The idea was that humans (more specifically homo economicus) act completely rationally and follow the principle of maximising utility, for which they posses and process seamless information. This assumption enabled macroeconomists to model rational behaviour through sophisticated and elegant mathematical equations. As a result, is-sues such as pride, jealousy, fear, greed, lack of knowledge as well as incomplete information were left out since they could not be modelled. It is therefore pretty obvious that if we all would be behaving like homo economicus, there would be no financial crises or large swings in asset prices (Abreu and Brun-nermeier, 2003). The failures of the EMH, therefore, gave birth to a new discipline, which has come to be known as behavioural economics, which at-tempts to explain the behaviour of Homo sapiens. In this article, we at-tempt to take stock from behavioural economics to shed light on volatile asset price movements and financial crises.
Homo economicus is all-knowing
The EMH postulates that homo-economicus is fully informed at all times, abstracting him from the existence of uncertainty and information costs. This merely implies that the homo-economicus is fully informed of alternative courses of action and can assess the consequences of those actions, weighted by probability of occurrence. However, it is true to assert that poor knowledge and insufficient information lay at the heart of the financial crises we experience. As Ben Bernanke (2010), chairman of the Federal Reserve in the U.S noted in his speech about the 2007-2008 financial crisis: “during the worst phase of the financial crisis, many economic actors- including investors, employers and consumers-metaphorically threw up their hands and admitted that, given the extreme and, in some ways, unprecedented nature of the cri-sis, they did not know what they did not know. The profound uncertainty associated with the ‘unknown unknowns’ during the crisis resulted in panicky selling by investors, sharp cuts in pay-rolls by employers and significant in-creases in households’ precautionary saving.” Even the most experienced investors, the math whizzes of Wall Street and financial regulators did not fully understand what was going on in the marketplace. Information seemed readily available, but it was totally useless at times. Institutional investors for example would need to read 30,300 pages worth of information for every Collateralised Debt Obligation (CDO) purchased to be aware of everything that was being acquired. When the effort required to access particular information is costly, key-industry resort to:
- Blindly believe the ratings given by rating agencies.
- Decide to hedge their risk.
“Get rich or die trying by finding a bigger fool”
For the former option, the rating agencies may be unaware as all other rating agencies, while the latter makes sense if the counterparty, that is deemed reliable, simply assumes that role; it only becomes problematic when the counterparty decides to hedge many other positions without asking anyone’s per-mission. For example, AIG, an American insurance firm, assumed the role of hedger-of-last-resort in the 2007-2008 financial crisis by betting that nothing would go wrong at once. This is similar to insuring all the houses in your neighbourhood against damage. You will make quick and easy money until natural disaster strikes. The worst case hap-pens when the counterparty resorts to re-hedge the position with another financial institution; the pass-the-hot-potato game goes on until it becomes almost impossible for anyone to know where the risk is eventually parked. Haldane (2009) notes that; knowing your ultimate counterparty’s risk be-came like solving a high dimension Sudoku puzzle given the complexity of the financial system. Also, generally, it is very difficult for people to correctly re-search and therefore assess the risks involved with borrowing money. This is evidenced by the U.S subprime mort-gage crisis in which people opted to purchase houses even though they had no jobs, no incomes nor assets. Most of them definitely committed themselves to ill-understood financial contracts on the premise that house prices can only go in one direction, namely upwards. We (humans) mostly neither have information about the exact costs of credit use nor the exact interest rate that would be most suitable plus the number of charges that ought to be paid (Berthoud and Kempson, 1992), the authors also argue that excluding credit cards and other sources of revolving credit, 8% of consumer credit decisions are made in the spur of the moment. Reasons why we tend to buy what we can’t afford include: we prefer to; Buy now, pay later-immediate rewards to us loom larger than delayed rewards (present-bias preference), this feeling becomes even stronger when we are more optimistic (Van Raaij and Gianotten, 1990). E.g. Let’s say I derive a utility (U) equal to $190 for purchasing a TV that costs (C) $200, I would definitely not purchase the TV set, assuming I get an opportunity to pay $46 every year for the coming five years, I am likely to purchase the TV set even if the interest rate is about 5% or less because, the reward is immediate and the price is payable at a later date. Get rich or die trying even if it means chocking on debt- be-sides individual motives to in-crease indebtedness, social motives such as social comparisons resulting in the desire to posses what others have play a significant role. All of us are familiar with the reality show (Keeping up with the Joneses- Haldane, 2009). Research shows we com-pare ourselves with others, such that if we have fewer financial resources to buy assets, goods or services compared to others, we may try to close this gap by simply borrowing since credit is widely acceptable and easily accessible. Get rich or die trying by finding a bigger fool- this is basically how asset bubbles come along, i.e. when some event, expecta-tion, development leads to a rise in the asset price, as asset prices rise, those who held back at first cannot hold back anymore when they witness the rise in wealth of their friends and relatives and eventually, everyone wants a piece of the pie. So investors buy the asset with the intent of selling at a profit to a bigger fool who is always expected to come along soon, guess what, this bigger fools do come by for some-time after which the demand be-comes unsustainable, panic sets in and the asset prices drop tremendously. We now get back to our previous endeavour of illuminating how our human side leads us into financial crises. Homo-sapiens hate doom mongers and love positive stories It has been said that confidence can be spread through contagion; the medium has generally been storytelling, where conversations, the media, books and magazines amplify the enthusiasm for the boom. Past bubbles have generally been fuelled by positive story telling. Common examples include the book titled “ Japan as Number One-Lessons for America”, became the number one best seller that launched a thousand other efforts in Japan hyping. In the decade prior to the burst of the Japanese bubble, many rooms in the western world were filled with people willing to hear a speaker tell of the wonders of the Japanese management scheme that were supposedly much ahead of the rest of the world. A couple of years later, specifically in 1996, the World Bank published a book titled “The East Asian Miracle” right before the Asian crisis erupted. And then again a number of years later (before the burst of the dot.com bubble), a glut of documents was witnessed arguing that there was a “New Economy-one in which the old rules of economics no longer applied”...similar content in the article (Michael Mandel, The Triumph of The New Economy,1996). Wondering what makes us tell and believe positive stories? Well that’s because we tend to form subjective judgements and make judgements solely in terms of observed similarities to familiar patterns (Tversky and Khanman, 1981). Thus the illusion of patterns makes us to expect past price in-creases to continue, ignoring historical experience that all skyrocketing asset prices eventually succumb to the laws of economic gravity. A few realists who do not get carried away by the irrational exuberance of the markets and instead give warnings before disaster strikes. An example would be in the 2007-2008 financial crisis Prof. Raghuram Rajan presented his controversial paper in the Jackson Hole Symposium titled “Has financial development made the world riskier?”, disappointingly, he was attacked by Donald Kohn, the then vice chairman of the Federal Bank, who thought the idea was too interventionist. Larry Summers, the former US treasury secretary, dis-missed the idea as being misguided. This shows that we tend to avoid con-tradictory information to our beliefs as much as possible.
According to the efficient market hypothesis, market prices are always right because they reflect the independent choice of market participants. It has been statistically proven that under conditions of independent random sampling, an aggregate collective judgement is more accurate than individual judgements. An empirical illustration is an experiment by Treynor (1987). The author made participants (56 of them) to make in-dependent judgements of the number of jelly beans in a jar (there were 850 in total), the estimate of the group as a whole was 871, only one of the participants made a more ac-curate judgement. This shows that the combined judgement of the group can outperform that of a single individual. In the context of financial crises, the herd often leads in the wrong direction that is according to history. This is often known as suffering from information cascades, by behavioural experts. We make decisions based on the observations of choices made by others preceding us even if our private information differs (Smith and Sorensen, 2000). Simply put, we find safety in numbers mainly because no one wants to be the only fool in the room. Portfolio managers are not left out in exhibiting this behaviour since their reward is for a large part based on relative performance; they in most cases tend to be cautious not to deviate from consensus.
Does history hit a nerve?Financial bubbles are well documented throughout history, but why investors fail to learn from past mistakes remains somewhat a mystery, we are oblivious of previous financial disasters (Galbraith,1993). It is when financial crises occur that investors realize that they have been suffering from what Reihart and Rugoff (2010b) call the this-time-is-different-syndrome, the belief that financial crises are something that happen to other countries e.g. Japan. This could partly be explained by the over confidence of portfolio managers, with the belief that their abilities are above average, which is an illusionary thought. We should be under no illusion that we will ever prevent asset bubbles and financial crises from taking place; the truth is they will be with us for as long we are human. To solve a problem, one has to find its root cause. It follows that, if humans bring about crises, then learning about our own psyche can be the most effective tool to fight crises, we need to under-stand that the world economy is a large complex, dynamic and unstable system in which one day people are optimistic about the future and they buy houses and cars and other assets while consuming more luxury ser-vices such as visiting restaurants and going on vacations. And then the next day, confidence vanishes for one reason or another. This can exert a downward pressure on prices causing a financial crisis. In short we should come to terms with the fact that we are bounded rational (Simon, 1956, 1982). In other words, we need to understand that some situations exceed our capacity to judge probabilities and make good decisions. This is evidenced by Isaac Newton’s experience after he lost money in the South Sea Stock bubble. We need to understand our own psyche to be able to make the right move in light of potential upcoming bubbles e.g. the Bit coin bubble, that has got its minors opposing the possibility of its crash even after the central bank governor warned of a possible crash. We should also appreciate the efforts of students who try to innovate insurance products that aim at reducing the severity of bubbles when they crash e.g. the product by a student known as Afanda Ian (Insuring the real estate bubble, 2017) during the K.P.M.G innovation challenge, that made it to the top five.
REFERENCES Abreu, D. And Brunnermeir, A.K. (2003). Bubbles and Crashes. Econometrical No.1
 De Grauwe, P. (2010b). When Financial Markets Force too much Austerity. CEPS
 Shahin Kamalodin (2011) Asset bubbles, Financial Crises and the Role of Human Behaviour. Rabobank
Mr. Afanda Ian, Author.Read Another Article