3.1 A psychological perspective on the global financial crisis

My own research with others over many years on the psychology of trading and investment gap ranks may shed some light on how the global financial crisis unfolded. The findings of our research revealed the complex emotional and psychological life of traders and their work. It was quickly clear that professional traders are just as prone to the biases and errors of thinking and errors of emotion that afflict other people. So let's set the scene briefly. Prior to the financial crash, a lot of financial institutions were making unusual levels of profit, trading financial products based on subprime mortgage loans. That is, high risk loans to buy housing at higher interest rates, given to people with poor credit records, and greater than average risk of defaulting on their loans. The risks of default, as they were understand then, were taken into account in setting interest rates. However, insufficient account was taken of the risk of economic events, leading to much higher than expected rates of default. Now any banker knows there's a fairly straight line relationship between risk and return. If you're making unusually high levels of return, when profits are high, then you're most often carrying unusually high levels of risk. So you would expect the bankers at the time to have been asking the question, if we're making unusually high profits, then what are the risks to making this possible? However, it turns out that mostly they weren't asking this question, preferring instead to believe that the profits were due to their unusual skill and the new highly complex financial instruments that they were using, and in many cases, understood poorly. Our research suggests some explanations for these dangerous beliefs. First, like the rest of us, traders don't like to feel anxious or fearful or have a bad opinion of themselves. Often, of course, faced with information or events creating these feelings, they would take action to fix the problems causing concern. However, faced with very exciting opportunities or reasons to be fearful, traders and senior bankers, like the rest of us, find ways of explaining away problems or discounting worrying information, and often focus on information that supports a positive view of their opportunities. One way of doing this is known as the illusion of control. That's the tendency that most of us have at some point when faced with uncontrollable events to believe and act as if we can exercise control over those events, despite the fact we could have no control over them. We don't like uncertainty and tend to polarise the beliefs that help us feel certain, a tendency we perhaps see in debates between rival camps about Brexit. It turns out that a good proportion of traders suffer from illusions of control, and our research shows that those that do are less effective at making judgments about risk. There is, of course, more to say about the role of individual psychological illusions in the global financial crisis. However, I want to turn to the need to go beyond psychology for a fuller understanding. Our work, as well as the work of people like David Tuckett, on financial markets also shows that the stories traders tell themselves about those markets don't just describe the markets, they also affect how they work, because the stories we tell ourselves about the world change the world we live in. What do I mean by that? Well, if I drop a brick, it's going to fall regardless of whether I believe in gravity or not. However, most of the facts in our world are social facts, which are only true so long as enough of us believe in them. Money is a good example. Money only works so long as enough of us believe in it and have a common story about how it works. The global financial crisis is also a tale of how the social facts about markets changed, and a tale about a collapse in belief in the stories about subprime mortgage investments. In the process, some more widely shared stories changed. Many people in this country would be familiar with the phrase, as safe as money in the bank. Very few use it anymore. So to get a fuller understanding of the crisis, we also need a more sociological understanding of how shared narratives construct our social world, the process by which they become social facts, and the ways in which those facts can change or break down.