Behavioral Economics & Great Recession of 2007-08

Behavioral economics sheds light on most everyday activities and why we consume goods and services the way we do, why we make certain choices about ourselves or others, and how we decide courses of action. It is an incredible lens that exposes our inner biases and approaches to decision-making.

Traditional economic research assumes that people’s economic decisions are based on the rule of maximizing utility. Behavioral economics, in contrast, neither assumes that people are good in utility maximization nor that it is people’s only goal. Using empirical tools, behavioral economists have shown rather that people have psychological biases, limited cognitive resources, and care about other values such as fairness, all of which might undermine their utility maximization behavior.

Understanding of behavioral Economics in terms of :

Economic Development: For developing countries, understanding human psychology is crucial for effective policy design. Behavioral economics can help policy-makers understand the cultural and psychological contexts of issues such as poverty, use of public goods, implementation of new programs, and so on.

Inequality and Discrimination by Race and Gender: Economic inequality is an issue of increasing concern to economists. Inequality exists both on the macroeconomic scale, in terms of broad income and wealth inequality, as well as in terms of race, ethnicity, gender, and other categories. Behavioral economics allows economists to better understand these forms of inequality based on how they relate to social norms and implicit bias. 

Environmental Issues and Climate Change: As climate change and environmental degradation become ever more pressing issues, leading to conflict, resource shortages, and other economic problems, behavioral economics can offer insights into understanding the causes and policy solutions to these issues

2007- 2008 Bubble

The 2007-2008 financial crisis was largely caused by the collapse of the housing bubble—the situation in which housing prices boomed, but eventually crashed. Part of this crash was due to how credit facilitated the rise in housing prices. In part, since many investors and consumers believed that house prices would continue to increase, credit flowed easily into the market, with the belief that this would be a sound and secure investment. As more consumers demanded houses and believed that prices would continue to increase, leading to herd behavior, market prices inflated further.

With the flow of easy credit, many mortgage loans were made with pernicious terms and held very high risk. When lenders realized many loans were going bad, the fire sale of mortgage-backed securities and other credit-backed products led to the eventual bust in the market. This massively reduced consumer and investor confidence and later caused the Great Recession.

Inference: The home price index increased drastically throughout the early 2000s.

 A behavioral economist’s analysis of the 2007-2008 financial crisis would show the tendency of investors to herd into speculative investments and then to herd out of the market once signals turned negative. We evaluate and view risk differently. While many individuals may tend to be risk-averse, in the situation of an emerging price bubble, our perceptions of seeing others herd into that investment may skew investors’ perceived risk and lead to irrational risk-taking.

 Why? 

Because we actually perceive little or no risk while in the midst of the bubble, Many see stock market crashes and crises as low probability, once in a generation event, investors often ignore the risk or assign it zero probability. Due to the availability heuristic, the probability of a financial collapse is difficult to imagine for many investors and consumers—we simply do not remember the last collapse or foresee another in the future. The inability to foresee a high-risk, but low probability event is sometimes referred to as an aspect of myopia or lack of foresight.

This relates to our tendency to overvalue the present and relate to discounting the future. Short time horizons and a tendency towards myopic thinking in part contribute to bubble dynamics and crises. 

Key Takeaways:

 

  • Behavioral economics refers to the attempt to increase economic theory’s explanatory and predictive power by providing it with more psychological foundations.

 

  • Behavioral insights allow us to begin building more realistic models of economic decision-making that regard both our psychological tendencies and our social context.

 

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