Behavioral Economics: The End of “Manly” Banking?

photo: herval

Wall Street’s bull statue stands as a symbol of unbridled capitalism. It also represents the inherent masculinity of the financial services industry.

But then came the 2008 Wall Street crisis, and with it, the collapse of the world economy. Suddenly, the manliness of Wall Street was severely dented. Images of newly unemployed bankers carrying boxes of personal belongings out of office buildings were screened around the world. The men in charge, like Hank Paulson, had lost control and had no clue what steps to take. And when Dick Fuld’s Lehman Brothers had to file for bankruptcy, leading to a worldwide loss of confidence in the market, the limits of mathematical models and the efficient market hypothesis were finally exposed.

The era of confidence was over, and attention shifted to the role of emotions and irrationality in economic behavior — essentially, the psychology behind economics.

The Psychology Behind Economic Behavior

Behavioral economics and behavioral finance are concerned with the psychology of economic and financial behavior.  These disciplines have been around for a while, but the financial crisis suddenly threw them in the limelight, and proponents like George A. Akerlof and Robert J. Shiller easily sold many copies of their book, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. The financial industry’s dream of a rational market was shot.

Our Financial Decisions Aren’t Rational

The study of behavioral economics aims to understand how psychological phenomena like emotions and group dynamics influence economic decisions. Studies have found that people often make decisions that are not in their best interest — or at least what economists consider their best interest.

For example, from a rational point of view, it’s best to start saving for retirement early in your career. But many don’t, and research shows that people are often terrible at long-term savings.

Investment decisions appear to be prone to all kinds of cognitive and emotional influences. Conventional economists always argued that irrational behavior couldn’t happen in financial markets. Irrational people may distort the perfect equilibrium of market prices, but savvier people would bring prices back to rational levels. But this equilibrium was hard to sustain after 2008. Behavioral economists, who often claim to have a more worldly and empirical approach than economists, who are occupied with models, refuted the belief that bankers behave rationally, carefully balance their decisions and only focus on maximizing their individual self-interests. Homo economicus clearly fell off his pedestal.

Groupthink, for example, has received part of the blame for the financial crisis. Collective beliefs and delusions, it is argued, arise and persist within groups like teams, firms, bureaucracies – and also in markets. Self-censorship, belief in inherent morality, collective rationalization, and stereotyped views of people outside the group are important symptoms.

Deluded By Success

Moreover, bankers and investors tend to be influenced by success stories. And if they belief in such stories, they become resistant to any evidence to the contrary. Besides, envy-inducing tales of young millionaires (and even the fictional Gordon Gekko in Wall Street) were a driving force for many to seek employment in the financial sector.

Business practices leading up to the financial crisis prove the disastrous consequence of ignoring evidence to the contrary of those practices. Hardly any banker could imagine falling housing prices, and they kept on selling all kinds of products backed by mortgages. Only a few hedge fund managers thought outside the box and saw the irrationality of the belief in ever-rising housing prices, as vividly illustrated in Michael Lewis’ The Big Short: Inside the Doomsday Machine.

Regulators Are Just As Irrational

Not surprisingly, the people who were supposed to supervise the bankers were also prone to groupthink and shared beliefs about the rationality of markets. In a brave move of self-reflection, a recent report from the International Monetary Fund’s (IMF) watchdog indicates that the fund fell victim to groupthink, preventing them — and I would argue, other regulators as well — from correctly identifying mounting risk within the financial markets. It was beyond their imagination that emotions and other psychological characteristics (such as herd behavior) could severely alter the world economy.

Does The Problem Lie With The Male Psyche?

Clearly, bankers and regulators operating in this overconfident environment were not sufficiently aware of their irrationality. But since these traits are so masculine, would we have avoided a crisis if mostly women were at the top? I doubt it. Despite increased awareness about the influence of irrationality and emotions in economic behavior, it would, however, be too soon to rule out risky masculine decision-making in the financial sector. Bankers aren’t suddenly doing deep soul-searching; entrenched habits and cultures are difficult to change. And power games (something behavioral economics tells us little about) between bankers and regulators about too-big-to-fail and bonuses demonstrate that, though Dick Fuld may have left the center stage, masculinity still thrives in the financial sector — be it rational or not.

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