Sunday, September 12, 2010

The Intersection of Psychology and Economics

In his NY Times column, Greg Mankiw offers advice to freshmen including this bit.

LEARN SOME PSYCHOLOGY Economists like me often pretend that people are rational. That is, with mathematical precision, people are assumed to do the best they can to achieve their goals.

For many purposes, this approach is useful. But it is only one way to view human behavior. A bit of psychology is a useful antidote to an excess of classical economics.

He also links to Fed Chairman Ben Bernanke's written testimony on the Causes of the Recent Financial and Economic Crisis. Bernanke's analysis includes these bits of psychology:

The evidence is more consistent with a view that the run-up in house prices primarily represented a feedback loop between optimism regarding house prices and developments in the mortgage market. In mortgage markets, a combination of financial innovations and the vulnerabilities I mentioned earlier led to the extension of mortgages on increasingly easy terms to less-qualified borrowers, driving up the effective demand for housing and raising prices. Rising prices in turn further fueled optimism about the housing market and further increased the willingness of lenders to further weaken mortgage terms.

And

The Federal Reserve had the authority to lend to depository institutions through the discount window; however, to a surprising extent, banks were reluctant to use the window, even when they had pressing needs for funding. This reluctance arose from the "stigma" of using the window; each bank feared that if it went to the window and markets learned they had done so, such action would be interpreted as a sign of weakness, and their funding problems would worsen rather than improve.

However, the Federal Reserve was able to supply liquidity to both banks and nonbanks, through a variety of means, to stem the panic. It auctioned fixed amounts of term funding to depository institutions, which seemed to circumvent the stigma problem.

I would suggest that the Chairman probably agrees with Mankiw's advice.

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