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The Genesis of the Financial Crisis: Greed and Repression

The self-healing market, the market that corrects itself, is at the heart of the perfect economic storm. The financial crisis (now banking, real estate, jobs,and credit crises) has forced a reconsideration of the role of the state. Psychology can help expose the religion of the market

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,  http://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.

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Decent overview 12.Jan.2009 13:47


But I doubt the actors had "feelings of incompetence" especially since they were so slick with it all. They might have, I don't know.

Cartoon introduction to the genesis of our financial shit-uation:

Excellent analyses from an anti-capitalist point of view:
"The United States and the world are now in the opening stages of the worst economic crisis since the depression of the 1930s. This crisis represents the greatest failure of the free market since the Second World War. For some time now, economists have argued that the market is self-regulating and self-correcting; this fantasy has been destroyed. The crisis has led to a run on the international banking system, a stock market crash, and has opened the door to what will be the longest and deepest recession of the post-Second World War period... There is no alternative, we were told, to the free market. What we are now told is that there is no alternative to government intervention and regulation."

And another analysis from much more of an insider:
"We are now in the end game; Treasuries are the last bubble, and when it bursts, we will find ourselves in a Depression that will make the 1930s look like a Cakewalk...

"I am no longer looking at a 1930s scenario as my base case; that has shifted to the panic of 1873, which was far worse than the 1930s and included widespread civil unrest. Go do some reading, and make sure you're sitting down. The parallels in the foundation of how that panic occurred - industrial shifts (US >> China) and insanely-loose mortgage credit (European in particular) are stunning - and troubling.

"If Bernanke won't cut this crap out, Congress needs to do so, and do it now. A replay of the 1873 Depression in today's society will be catastrophic, with unemployment reaching 30% or more and leaving essentially everyone - corporate or otherwise - carrying any form of debt wiped out. Deficit spending will become instantly impossible; go figure out what that does to the Federal Budget.

"We are running out of time to stop that outcome and if effective action is not taken before the Treasury Bubble pops it will, quite simply, be too late. That genie is not the friendly sort, and once he pops out there is no stuffing him back into the bottle."

Karl Denninger's plea to stem revolution: