Psychological games and financial crises

At Pieria, the financial crisis remembered.....

Five years on from the collapse of Lehman, I explain the psychological game-playing that caused the 2007/8 financial crisis - and that still continues today.
"One of the interesting features of financial and economic crises is their suddenness. It's as if the world is happily strolling along a well-trodden path on which someone has built a man-trap. We don't see the crash coming and we walk straight into it. Yet when we look back on what happened, we see all too clearly that the signs were obvious - we just didn't notice them.
"Economists have made numerous attempts to explain this apparent blindness without a great deal of success. The fact is that financial crises do not come out of the blue, and some people do see them coming. The world is warned about its folly, but chooses to ignore. Those who shout "WATCH OUT - THERE IS DANGER AHEAD" and try to suggest alternative courses of action are dismissed as Cassandras and their thinking is excluded from mainstream academia and the corridors of power. This suggests that the cause is more psychological than economic - it is rooted in people's behaviour. Like a Greek tragedy, the end is inevitable because of the nature of the players."
Read more here.


  1. Nice one. May I suggest a name for the austerity game? It would be "I am more prudent than you are."

  2. As a non-economist this seems to make sense. But Frances, how should the allocation be different?

    I understand the answer will be more than a dozen lines. Sorry.

  3. Its all very well as game playing but the ones who are the loosers are the prudent ones for whom austerity is the norm and whose savings have been plundered to bail out the profligate
    Equally galling to hear that all creditors secured or no secured from Lehman collapse are set to get 100% return

    Shame it wont apply to all those who have lost so much in Pensions , Annuities or savings income

    1. You have completely failed to understand the post.This post is not about savings. Nor is it about the morality of austerity or profligacy, nor about who deserves what.

      This site is not a place for you to grandstand your views. I will not accept further comments from you that do not address the subject of the post.

  4. I think what you write here has a lot to do with trend-following by people who are unaware of context. I was fortunate enough to get out of the Market in the Fall of 2007 and saved myself a good deal of money in the process, but I found it was quite a psychological struggle to do so. I needed a context within which to think.

    One the one hand I saw the count of bankrupted small US Mortgage companies rising, eventually reaching the hundreds, and I read stories of widespread fraud in mortgage applications. That suggested to me that sooner or later Banks would be sitting on masses of bad assets, and that would lead to reduced lending. I won't pretend that I predicted the scale of the crisis when it came, but I sensed something bad coming.

    On the other hand, the market seemed to be ignoring the whole thing, and I have a tendency to believe that the Market knows more than I do. It has known better than me in the past.

    What tipped the balance for me was having a framework to put things in. I bought a copy of Friedmann and Schwartz in the early 2000s, and have read the Chapter on the Depression, "The Great Contraction", several times. It was that story that convinced me that the financial system could be much less strong that it appeared, and that worse could be coming than the market seemed to expect. My thanks to the authors.

    What puzzles me today is that so many people still write and comment as if we live in a week-to-week World. I think we live in a World whose ten year picture is that of a classic Minsky Moment, with the inflection point in 2007, and if you keep that in mind you can actually make a good stab at understanding where we are, month to month. So today I am as puzzled by the people who are currently predicting a melt-down, hyperinflation or economic collapse coming, as I was puzzled in 2007 by people who predicted no trouble ahead.

    We've had the financial collapse and the Minsky Moment, then the half decade of de-leveraging and QE, and the Banks are finally back to profitability, so now we should expect further recovery in the real economy. But hey, maybe further recovery just isn't melodramatic enough for some people.

  5. The financial crisis unfolded slowly. US housing prices were falling by Q3 2006, mortgage delinquencies and the subprime collapse was through 2007, but QE and TARP weren't until October 2008.

    I saw large mortgage market losses coming. But in probably late 2007 I found out that a large investment bank was cutting all counterparty risk with Bear Stearns. I then realized that it wasn't just about mortgages and that the whole financial system was in terrible danger. It scared the hell out of me. It must have also been realized by thousands in the southern half of the island of Manhattan.

    Rather than confronting losses and leverage, there was delay and even deception. Regulators were accomplices. Eventually something would force disclosure, and that was Lehman's breaking of the money market funds. That was the sudden psychological shock most people remember.

    The widespread realization that there is a great risk that we don't fully understand will create an exodus of risk taking. We may call it a panic, but it is entirely rational behavior.

    The financial phantasma has three parts: denial, suddenness, and confusion. The denial is maddening because it is avoidable, and exacerbates the sudden fear and confusion. That's why we need good regulation and law enforcement.

    But worse than the actual trauma is the memory of it that reduces our risk taking in the form of lower consumption and investment for years to come. We need to learn from our mistakes and correct them so well that we don't fear them in the future. We have failed, and that's what makes the anniversary so poignant.

    1. The psychological shock in the UK was the fall of Northern Rock in September 2007. Lehman was bad, followed as it was by HBOS within 3 days and RBS less than a month later, but it doesn't remain in folk memory here the way that the Northern Rock retail run does. US people didn't notice the 2007 shock so much because the FHA bailed out the lenders affected. That's why you regard Lehman as the bigger shock.

    2. Those in the financial industry tend to have different memories of specific catalysts depending on their individual experiences. Mine is Bear, though I think the shut down of the commercial paper market due to Lehman's bankruptcy was the most far reaching.

      At least in the US, I don't think most people, or even loan officers, can identify a particular institution that is responsible - though some will repeat what they heard from their ideology's punditry. Regardless, they still live in greater fear of lay offs, benefit cuts, falling asset values, halts in lending, and defaulting loans.

      To quibble a bit, in 2007 the delinquencies were just beginning and surprisingly unrecognized in financial statementments. It was thought to be just a subprime lender problem. I think there was an organized effort to inflate mortgage credit derivative values. FHA didn't matter much. Ultimately, the losses of many of the worst mortgages were just sucked up by whomever was holding the securities. The horror of securitization tranches is that everyone's at risk, but no one is responsible.

    3. Kent,

      I don't wish to argue, but the financial crisis really was a series of massive traumatic bank runs. Mortgage delinquencies themselves can cause bank failures, but not systemic crises. The reason for bank runs is always that creditors believe the bank will run out of money, and that is as true of wholesale runs on shadow banks as it is of retail runs on commercial banks. Therefore the belief shift must have happened when the first bank run occurred.

      The fact that the US weathered the ABCP run without bank failures is the reason why it is widely ignored as the catastrophic event that it really was. But it really was the start of the financial crisis. Prior to that, there were rising subprime delinquencies and falling house prices, which were certainly serious warnings that the system was in trouble. But from August 2007 onwards there were repeated runs on the shadow banking system. The repo run after Reserve Primary was the largest and most traumatic, but the ABCP run was the first. That's why I say the psychological "switch" was in August 2007, not September 2008.

  6. I agree. Bad loans and excessive leverage can lead to insolvent institutions, but a bank run (or similar) is the tipping point. What was so different, at least in the US, is that there were no lines of consumers waiting to withdraw money at retail banks. Commercial depositors were pulling money and commercial paper had seized up, but consumers didn't see that as their problem because of deposit insurance.

    Before August 2007 only the Cassandras were scared, but then almost everyone in the financial industry was terrified. It wasn't until the second half of 2008 that the US unemployment rate was skyrocketing and the government was writing monstrous bailout checks. At that point, even the rank and file were shocked, sometimes in spite of conservative media trying to downplay problems before the 2008 elections.

    That's the really weird part about the crisis. We didn't all realize it at the same time. If you know it and the people around you don't, then it is surreal. Sorry, I'm not disputing the historical course of events as much as how I felt at the time. It was as if "time was out of joint".


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