Asset bubbles, fin crises and the role of human behaviour

Author: Shahin Kamalodin
Economic Research Department
Asset bubbles, financial crises and
the role of human behaviour
January 2011

January 2011 Rabobank Economic Research Department 2
Table of contents
Table of contents 2
Crises & Human Behaviour 3
Abstract 3
Crises are nothing new 4
An economic theory of everything? 7
Key takeaways 18
References 21
Colophon 24
Author: Shahin Kamalodin
S.A.Kamalodin@rn.rabobank.nl
+31 (0) 30 2131106
The views expressed in this paper are his own and not necessarily those
of Rabobank.
Additional economic studies can be found on our website:
www.rabobank.com/kennisbank
Completion date: 6 January 2011

Crises & Human Behaviour
Abstract
Every time we witness a collapse in asset prices or a financial crisis, we seem
overwhelmed. Even the most experienced investors, economic forecasters and
regulators are caught off-guard. But if we look closer at the historical data for
the past two centuries, we see that asset bubbles and financial crises are
nothing new to mankind. The first documented asset bubble happened in 1636-7
(the Dutch tulip mania) while the first documented global financial crisis goes
back to 1825. Regrettably, in the following decades we went through numerous
other bubbles and financial crises.
Against this backdrop, we must ask ourselves, why do we experience these
events at such high frequency? Most market participants believe that (i) easy
money (low interest rates and loose credit conditions), (ii) lack of proper regu-
lation and (iii) greedy financial speculators (e.g. bankers, hedge fund managers,
etc) lie at the heart of the problem. There is no doubt that these factors played
an important role in most asset bubbles and financial crises in the past. But they
are proximate causes nonetheless. In this report, we are more in search of the
ultimate cause of these events. The only common denominator we can think of
is human behaviour.
In our view, human behaviour offers the best and most comprehensive
explanation for recurring financial crises and volatile asset price movements.
This entails both good and bad news. The good news is that once we form a
deep understanding of our own psyche, we should be slightly more successful in
spotting impending crises. As for the bad news, until we carry on behaving like
we do (i.e. as humans), we will never have a crisis-free world. No one
should be under an illusion that we can ever win the war on economic crises.
Reducing their frequency and severity is the most we can ever hope for.

Crises are nothing new
Not a single year has gone by in the past two centuries where there was not a
financial crisis somewhere in the world (see figure 1). It is important to note
that financial crises are usually preceded by housing market and stock market
booms and busts (Bordo, 2003), which have
been very recurrent episodes, unfortunately
(see figures 2 and 3).
Arguably, the world witnessed its first inter-
national financial crisis in 1825 (Neal, 1998).
The opening up of Latin America after the
overthrow of the Spanish empire led to the
opening up of international trade between
England and the Latin American republics. The
result was massive capital flows from London
to finance infrastructure, mining and
government deficits. This led to a boom on the
London stock exchange. But once the capital
outflows impinged on the Bank of England’s
(BoE) gold reserves, the policy rate was
raised, leading to a stock market crash and a banking panic. A sudden stop of
capital flow from London resulted in debt defaults, banking panics, currency
crashes across Latin America (Bordo and Landon-Lane, 2010).
The crisis of 1873 had a global reach too. It started with the collapse of a
property boom in Germany and Austria (Kindleberger, 2005), then spread
through the continent and affected the US as European investors dumped US
railroad stocks. The US had a major panic associated with a corporate
governance scandal in the railroad sector (Benmelech and Bordo, 2008).
Subsequently, the crisis spread to Latin America via a sudden stop of capital
Figure 1: World economy is very crisis-prone
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60
70
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100
0
10
20
30
40
50
60
70
80
90
100
Proportion of countries that experienced a financial crisis (banking crisis,
currency crash and/or sovereign default)
% of total % of total
History of financial crises
(70 countries)
End of WWI
The Great Depression
Latin American crisis
The crisis of 1825
Bretton Woods
The crisis
of 1873
Nordic, ERM, Tequila, Asian Flu,
Russian Cold, Brazilian fever, LTCM
Source: Reinhart and Rogoff (2010), Rabobank
Figure 2: Housing markets crash very frequently... Figure 3: ...but not as frequently as stock markets
-60 -50 -40 -30 -20 -10 0
Hong Kong (1997)
Philippines (1997)
Colombia (1998)
Finland (1991)
Indonesia (1997)
Norway (1987)
Japan (1992)
Ireland (2007)
Spain (1977)
US (2007)
Sweden (1991)
Argentina (2001)
Norway (1899)
Korea (1997)
Thailand (1997)
UK (2007)
Malaysia (1997)
Denmark (2007)
Spain (2007)
US (1929)
%-points
Real house price declines (peak-to-trough)
following financial crises
Blue bars: it is undertain whether
trough is reached
Source: Reinhart and Rogoff (2010), Rabobank Source: Reinhart and Rogoff (2010), Rabobank

flows as the BoE raised its policy rate once again to offset gold outflows. This led
to a series of debt defaults across the region and a banking crisis in Peru.
A few years later the Baring crisis started
(1890), which was the worst crisis the advan-
ced countries suffered since the end of the
Napoleonic era (see figure 4). In the 1880s,
the Western European countries exported
capital to the Latin American countries for
infrastructure investment. Major recipients of
these funds were Argentina, Uruguay and
Brazil. The associated land boom financed by
generous bank lending conditions ended in a
bust when the BoE and other European central
banks began raising their policy rates to stem
losses in their gold reserves. The sudden stop
of capital flows led to a banking crisis, debt
default and currency crisis in Argentina.
Barings Brothers (a leading London merchant
bank at the time), which was heavily exposed to Argentine debt, became
insolvent. Subsequently, panics did occur in numerous European countries,
Japan, the US, Australia and New Zealand. In addition to Argentina, other Latin
American countries affected were Brazil, Chile, Uruguay and Paraguay.
As soon as we stepped foot into the 20th
century, the advanced countries were
hit by the panic of 1907, which started in the US after the stock market fell
close to 40% from its peak (end-1906). Countries that were hit were France,
Italy, Denmark, Sweden and Japan. Almost a decade later, the world
experienced another major financial crisis. The crises at the end of WWI
reflected the attempts by central banks around the world to unwind the inflation
that had built up during the War. Disinflation impinged upon the balance sheets
of many European countries leading to banking crises in the Scandinavian
countries, the Netherlands, Italy, Japan, Mexico and elsewhere.
Then came the mother-of-all-financial-crises – the Great Depression. This
episode was preceded by stock market booms (‘the Roaring 20s’) that crashed in
the US and UK in the late 1920s. A series of banking panics in the US beginning
in October 1930 were not successfully allayed by the Federal Reserve (Friedman
and Schwartz, 1971) and this turned the situation from bad to ugly. The
depression was transmitted around the world by the fixed exchange rate links of
the gold exchange standard and numerous protectionist measures. Many coun-
tries across the world were finally hit by debt and currency crises.
After WWII, the world economy entered a period of relative calm. This was
primarily due to the Bretton Woods (BW) system. In this era, currencies were
Figure 4: Crises in the industrialised world
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60
70
80
90
100
0
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20
30
40
50
60
70
80
90
100
Proportion of advanced countries that experienced a financial crisis
(banking crisis, currency crash and/or sovereign default)
End of Napoleonic era
End of WWI
The Great Depression
Beginning of WWII
The Baring crisis
ERM, Nordic
The Panic of 1907

kept fixed, capital controls were widespread and financial regulation was strictly
designed to prevent a reoccurrence of the financial chaos of the interwar period.
Once the BW system broke down in 1971, the global financial economy re-
opened and capital flows surged. In addition, amid high inflation rates many
controls on the financial system began to crumble. So the financial crisis
problem of earlier eras made an unfortunate comeback.
Banking crises erupted in both advanced and emerging countries in the 1970s.
In 1974 in the US, Franklin National bank was bailed out while in Germany
Herstatt bank was not. But neither of these events was considered to be a
classic banking crisis. Other European countries witnessed significant bank
failures as did other parts of the world. In the emerging countries there were
scores of currency crises. At the end of the 70s the US and other advanced
countries shifted to a very tight monetary policy to break the back of inflationary
expectations. Tight monetary policy and the ensuing recession in the West led
many countries in Latin America and elsewhere to default on debts built up in
the preceding inflationary era. The Latin American debt crisis beginning in
1982 (countries directly affected were Mexico, Argentina, Chile and Ecuador)
triggered financial difficulties for banks across the world. In the US, key banks
like Chase and Citibank needed to be bailed out (Bordo and Landon-Lane, 2010).
The last decade of the 20th
century was full of crises. In the early part of the
1990s, Sweden and Finland experienced a property boom. The bust was
triggered by the breakdown of the Soviet empire. These forces produced the
Nordic financial crisis (Jonung and Hagberg, 2005). Banks also failed in
Norway. Other countries like Italy and Australia also had banking crises in this
period. Around the same time, the European currency crisis started after
George Soros, a hedge fund manager, speculated against the sterling and forced
the UK to exit the ERM. Subsequently, a number of currencies in Europe came
under attack by specuators. Two years later, the tight policy of the Fed triggered
a massive devaluation by Mexico, which led to a banking crisis. The contagion
resulted in other Latin countries being hit (the Tequila effect).
In the second half of the 1990s, crisis made land-fall in the East. The Asian Flu
started when external debt-financed boom came to an abrupt halt amid moun-
ting speculation against the Thai Baht in 1997. The devaluation of the baht
increased pressure on the rest of the currencies in the region and finally resulted
in currency and banking crises in Thailand, Indonesia, Korea as well as less dra-
matic disruption in Hong Kong, Malaysia, the Philippines and Taiwan. The Asian
Flu had contagion effects on other emerging countries partly reflecting tighter
lending conditions of Western banks. Two prominent countries were Russia which
defaulted on its debt in 1998 (the Russian Cold) and Brazil which had a serious
currency crisis (the Brazilian Fever) in the same year. The Russian crisis also
managed to push Long-term Capital Management, a hedge fund, towards
bankruptcy as it was greatly exposed to Russian debt (the LTCM crisis).

An economic theory of everything?
So it is clear that collapse in asset prices and financial crises occur quite
regularly and mostly have devastating macroeconomic consequences for the
countries involved. Millions of jobs are lost when countries experience crises and
billions of dollars worth of wealth are wiped-
out within a very short period of time. What is
less clear, however, is the reason why they
take place. Forming a sound understanding of
their underlying causes is of utmost
importance to investors, policymakers and all
other stakeholders.
The explanations offered by experts often boil
down to three causes: (i) easy money (low
interest rates and loose credit conditions), (ii)
lack of proper regulation and (iii) greedy
financial speculators (e.g. bankers, hedge fund
managers, etc). There is indeed a long laundry
list of factors (variables) that can explain
failing asset prices and financial crises (see
figure 5). But we believe these reasons serve as proximate causes. The
ultimate cause, in our view, is human behaviour. After all, without our animal
spirits there will be no asset bubble or financial crisis (Akerlof and Shiller, 2009).
From homo economicus to homo sapiens
Throughout most of the second half of the 20th
century, the efficient market
hypothesis (EMH) was broadly accepted by economists. The idea was that
humans (or more specifically homo economicus) act completely rationally and
follow the principle of maximising utility, for which we possess and process
seamless information. This assumption enabled macroeconomists to model
rational behaviour through sophisticated and elegant mathematical equations.
And issues such as pride, jealousy, fear, greed, lack of knowledge as well as
incomplete information were left out since they could not be modeled.
It goes without saying that if we all would be behaving like a homo economicus,
there would be no financial crises or large swings in asset prices (Abreu and
Brunnermeier, 2003). The failures of the EMH, therefore, gave birth to a new
discipline, which has come to be known as behavioural economics. This relatively
new branch of economics attempts to understand the behaviour of homo
sapiens. In this report, therefore, we will take stock from behavioural economics
to shed light on volatile asset price movements and financial crises. Note that
some of the theories proposed are closely linked to one another.
Have you ever met Mr. Know It All?
In its ‘pure’ form, the EMH postulates that homo economicus is fully informed at
all times, abstracting him from the existence of uncertainty and information
Figure 5: Many variables explain financial crises
0 25 50 75
Low levels of international reserves
Appreciation of real exchange rate
Sharp drop in GDP
Rapid credit expansion
Large current account deficit
Surge in money supply
Change in exports/imports
High inflation
Sharp drop in equity returns
Strong rise in real interest rate
Unfavourable debt composition
Large budget deficit
Worsening terms of trade
Contagion
Weak political/legal infrastructure
Surge in capital flows
High external debt
% of academic studies where
"leading indicator" was found to be a
relatively good predictor of financial
crisis.
%
No. of studies=83, covering 1950-2009
Source: Frankel and Saravelos (2010), Rabobank

costs. This does not mean that we actually foresee the future. It merely implies
that we are all fully informed of the alternative courses of action and can assess
the consequences of those actions, weighted by probabilities of occurrence.
However, we can see that poor knowledge and
lack of proper/costless information lay at the
heart of the current mess we find ourselves in.
As Ben Bernanke (2010), Chairman of the
Federal Reserve, noted in his speech: “during
the worst phase of the financial crisis, many
economic actors –including investors, employ-
ers, and consumers– metaphorically threw up
their hands and admitted that, given the
extreme and, in some ways, unprecedented
nature of the crisis, they did not know what
they did not know. The profound uncertainty
associated with the ‘unknown unknowns’
during the crisis resulted in panicky selling by
investors, sharp cuts in payrolls by employers,
and significant increases in households' precautionary saving.”
Even the most experienced investors, the math whizzes of Wall Street and
financial regulators did not fully understand what was going on in the market-
place. Information seemed readily available, but it was totally useless at times.
Institutional investors, for example, would need to read 30,300 pages worth of
information for every collateralised debt obligation1
(CDO) purchased to be
aware of everything that was being acquired. For understanding the risks of a
CDO-squared, 1,250,000,300 pages had to be read (Haldane, 2009). Since
almost no one had the time to read that many pages, investors either (i) blindly
believed the ratings given by rating agencies or (ii) decided to hedge their risk.
As for the former, it was clear after multi-notch rating downgrades during the
crisis (see figure 6) that rating agencies had been as unaware as all other
investors. The latter case is even more interesting. Financial institutions very
often opted to purchase credit default swaps (CDSs) to hedge their positions on
asset-backed securities (ABSs). This makes sense if the counterparty, that is
deemed reliable, simply assumes that role. It only becomes problematic when
the counterparty decides to hedge many other positions without asking anyone’s
permission. For example, the AIG, an American insurance firm, assumed the role
of hedger-of-last-resort by betting that nothing would go wrong at once2
. This is
similar to insuring all houses in your neighborhood against damage. You will
1
CDOs are a type of structured asset-backed security (ABS) whose value and payments
are derived from a portfolio of fixed-income underlying assets. These assets could be
company loans, student loans, home mortgages, etc.
2
The AIG had written over USD 400bn of CDSs on subprime mortgage securities.
Therefore, the US government had to extend USD 170bn of loans to keep the firm afloat.
Figure 6: Rating downgrades
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100
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AAA AA A BBB BB B >CCC
Alt-A and Prime RMBS Subprime RMBS RMBS-backed CDOs and SIV-Lites
% %Ratings of originally AAA-Rated U.S. mortgage-related securities
(In percent of S&P ratings for 2005–07 issuances - July 31, 2010)
Note: RMBS = residential mortgage-backed security
CDO = collateralized debt obligation
SIV = structured investment vehicle.
Source: S&P

make quick and easy money until natural disaster strikes. What’s more, the
counterparty very often re-hedged the position with another financial institution.
This pass-the-hot-potato game went on and on until it became almost
impossible for anyone to know where risk was
eventually parked. At the end of the day, as
Haldane (2009) notes, knowing your ultimate
counterparty’s risk became like solving a high-
dimension Sudoku puzzle given the complexity
of the financial system (see figure 7).
Not only are complex financial products
difficult to understand, but so are the simplest
concepts. In the Netherlands, the AFM
(financial regulator) forced credit providers to
place the sentence Let op! Geld lenen kost
geld on their ads from April 2009 onwards.
The literal English translation is “Attention!
Borrowing money costs money”. Interestingly,
the survey of the AFM conducted in Dec. 2009,
shows that 77% of respondents found the
sentence useful as it made them rethink about the costs associated with
borrowing money. This means that it is very difficult for people to correctly
assess all the risks involved with borrowing money. The US subprime crisis also
made this point painfully clear, as people opted to purchase houses even though
they had no jobs, no incomes nor any assets. Many clearly committed
themselves to ill-understood financial contracts on the premise that house prices
can only go in one direction, namely upwards.
This finding should not come as a surprise to behavioural economists, however.
Berthoud and Kempson (1992) argued that we mostly lack information about the
exact costs of credit use, and we know neither exactly which interest rates
would be reasonable nor how many charges ought to be paid. The authors also
report that, excluding credit cards and other sources of revolving credit, 8% of
consumer credit decisions are made in the spur of the moment. So this brings us
to this question: why do we buy what we cannot afford? Below are a number of
explanations.
Buy now, pay later
Research has consistently shown that immediate rewards loom larger than
delayed rewards (Garling et al., 2009). This means we usually have a present-
bias preference –we focus more on the present and prefer to spend our money
immediately rather than later (Frederick et al., 2002). This feeling becomes even
stronger when we are more optimistic (Van Raaij and Gianotten, 1990). Present-
bias preference can be better understood through the following example.
Assume that Mr. Smith derives a utility (U) equal to €190 for
Figure 7: Global financial network (2005)
Source: Haldane (2009)

purchasing a TV that costs (C) €200. In this case, he will abstain from
purchasing the product (since U<C). Now let us assume that Mr. Smith gets an
opportunity to pay €46 every year for the coming 5 years. Again Mr. Smith
would not buy the TV if the interest rate in the five year period was 5% or less.
This is because the present value3
(PV) of the TV would be at least €200.
But studies show that Mr. Smith is much more likely to purchase the TV with a
loan if he has a present-bias preference (Meier and Sprenger, 2008). This is
because the reward is immediate and the price is payable at a later point of
time. Experiments show that the costs of a product appear to be even smaller as
periodic installments are rather low amounts (Garling et al., 2009).
Get rich or die tryin’ (by choking on debt)
Besides individual motives to increase indebtedness, social motives, such as
social comparisons resulting in the desire to possess what others have, play an
important role (keeping up with the Joneses – Haldane, 2009). Research
shows that we compare ourselves with others. If we have fewer financial
resources available to buy assets, goods or services compared to the others, we
may try to close this financial gap by simply borrowing. As Kindleberger and
Aliber (2005) argue “there is nothing as disturbing to one’s well-being and
judgment as to see a friend get rich.’’ So this results in the society being divided
into two classes—the haves, and the have-not-paid-for-what-they-haves.
One important reason why we borrow more to increase spending is because
credit use has become socially acceptable in most parts of the world (Gross and
Souleles, 2002). For that matter, it is no longer shocking to see our neighbor
stepping out of his mortgaged-home to drive his leased car with credit-card gas.
Another reason for borrowing is greater credit availability (Soman, 2001). We
usually have difficulty refusing money when offered on very lax conditions. And,
unsurprisingly, our propensity to consume increases when borrowing is made
possible. Research has shown that tipping, the amount spent in department
stores and the willingness to increase offers in an auction for event tickets
increase if we pay by credit card instead of cash (Feinberg, 1986; Prelec and
Simester, 2001). What is disturbing though is that we take no account of the fact
that over indebtedness causes serious problems in the household (DeVaney and
Lytton, 1995; O’Neill, 1995). For instance, Brown et al. (2005) found that
households with outstanding debt are likely to report lower levels of
psychological well-being than are households without debt.
Get rich or die tryin’ (by finding a bigger fool)
History has shown that overconsumption and, especially asset price bubbles,
occur even when credit is not readily available. Asset bubbles, which sadly have
3
The calculation of the PV is done through the following formula.
         
200
05.01
46
05.01
46
05.01
46
05.01
46
05.01
46
54321










PV

a very long history, have been an interesting topic for behavioural economists.
Bubbles are formed when some event, expectation, or development leads to a
rise in the asset price4
. As asset prices rise, those who had held back at first
cannot resist anymore when they witness the
rise in wealth of their friends and relatives.
Eventually everyone wants a piece of the pie.
So a vacuum is generated that sucks in more
investors that try not to fall behind. By now,
we mostly ignore the original stimulus for the
boom, and we only buy with the intent of
selling at a profit to ‘‘a bigger fool’’ who is ex-
pected to come along soon. For some time
these bigger fools do actually come by. At the
peak of the tulip bubble, February 1637, an
auction of tulips netted 90,000 guilders. For
comparison, this was around 100 times the
annual salary of a prosperous merchant at the
time. The stock of the South Sea company
soared almost ten-fold in a matter of months.
Valuations also went crazy before the burst of the dot.com bubble (see figure
8). For instance, Priceline.com, which was a travelling agency selling airline
tickets below their purchasing price (an unsustainable, if not crazy, business
model), went public in 1999 and saw its share price rise from $16 to $85
(+530%) in a single day. A month later, the share price reached $120, which
made the firm more valuable than the three largest American airlines
(Continental, North West and United) put together (Rapp, 2009).
Valuations were also out of whack in Japan during the 1980s. At their peak in
December 1989, Japanese stocks had a total market value of about $4 trillion,
around 1.5 times the value of all U.S. equities (even though Japanese GDP was
less than half of US GDP at the time) and close to 45% of the world’s equity-
market capitalisation. Within this period of euphoria, the price/earnings (P/E)
ratio jumped from under 25 to over 60 in 1989. The result was highly
overvalued companies. Of the ten largest companies in the world, according to
market capitalisation, seven were Japanese in 1989 (in 2007 only one company,
Toyota motors, remained in list). The value of NTT Corporation, Japan’s
4
Consider the following examples: The first documented asset bubble, the ‘‘tulip craze’’
that took place in the Netherlands in 1636–1637, started when some bulbs became
infected with a nonfatal virus that produced rather bizarre contrasting colored stripes. The
South Sea bubble started when the company was given a monopoly over all trade to the
South Seas. The advent of widespread electrification, the lowered cost and greater
distribution of automobiles, and the technical advances in industrialization, gave rise to the
1920’s bubble in the US stock market. At one point in time, almost everyone in America
was turned on to stocks and checking with local brokers became part of everyday life.
Similarly, the advent of microelectronics, the personal computer, e-mail, the internet, the
laser, and other advanced technologies made many believe that productivity was reaching
to new levels. This resulted in the dot.com bubble.
Figure 8: Valuations matter!
0
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50
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45
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1880 1900 1920 1940 1960 1980 2000
US S&P 500
(cyclically adjusted price-earnings ratio, CAPE)
The peak before the
Great Depression
The dot.com bubble
Source: Robert Shiller’s dataset, Rabobank

telephone giant, which was privatised during the boom, exceeded the value of
AT&T, IBM, Exxon, General Electric, and General Motors combined. The boom in
real estate prices was as dramatic. From 1955 to 1990, the value of Japanese
real estate increased more than 75 times. Before the burst of the bubble, the
Japanese could have bought all the property in America by only selling
metropolitan Tokyo (Rapp, 2009).
All these events show that we are not necessarily ‘fools’, in the real sense of the
word, but we get sucked in by bubbles when we see others (be it our own
friends or competitors) become wealthier by the day. Put differently, we do not
want to miss the train to prosperity even if we are aware that the there is a
chance that it might blow up in one of the next stations.
We just love positive stories...
One of the primary reasons why we get sucked into bubbles is because of the
nice stories we tell each other. Behavioural economists have long argued that
stories and storytelling are fundamental to human knowledge (Akerlof and
Shiller, 2009; Schank and Abelson, 1995). Just as diseases spread through
contagion, so does confidence, or lack of confidence. The medium in this case is
storytelling by individuals throughout society (it becomes a social contagion).
Apart from conversations, the media, books and magazines further amplify the
enthusiasm for the boom.
The past bubbles were, by and large, fueled by positive storytelling. Every crisis,
in that sense, boils down to a crisis of success. For example, during the boom
years of the 1920s, there were many articles and press releases encouraging the
bubble. An article from Ladies’ Home Journal in 1929 was titled “Everybody
ought to be rich”. Not only were waitresses, taxi drivers, barbers and shoeshine
boys giving stock advices, but also well-known economists were sucked in by
the hype. A few days before the stock market crash of 1929, Irwing Fisher
insisted: “Stock prices have reached what looks like a permanently high plateau.
I expect to see the stock market a good deal higher than it is today within a few
months.”
Another example was the book “Japan as Number One—Lessons for America”,
which became a 1979 bestseller that launched a thousand other efforts in Japan
hyping. In the decade prior to the burst of Japanese bubble, many rooms in the
Western world were filled with people willing to hear a speaker tell of the won-
ders of Japanese management schemes that were supposedly far ahead of the
rest of the world. A couple of years later (1996), the World Bank published a
book titled “The East Asian Miracle” right before the Asian crisis erupted. And
then again a number of years later (before the burst of the dot.com bubble), we
witnessed a glut of articles arguing that there was a ‘‘New Economy - one in
which the old rules of economics no longer applied”. Michael Mandel, who served
as Business Week’s economics editor, wrote articles entitled “The Triumph of the

New Economy” and “The New Growth Formula” in which he argued that high-
technology was now the driving force in the US economy.
You may wonder what causes us to tell positive stories. One reason is that we
form subjective judgments and make judgments solely in terms of observed
similarities to familiar patterns (Tversky and Kahneman, 1981). Thus, the
illusion of patterns makes us expect past price increases (even if for a very
short period) to continue. We all ignore the historical experience that all
skyrocketing asset prices eventually succumb to the laws of economic gravity.
Another explanation is that we simply like to believe in positive stories.
This is evident from structural bullishness of equity analysts. Mckinsey’s (2010)
study shows that equity analysts covering the US S&P 500 have been persistent-
ly overoptimistic for the past 25 years, with earnings estimates ranging from 10-
12% a year, compared with actual earnings growth of 6%. Over this time frame,
actual earnings growth surpassed forecasts in only two years, both during the
earnings recovery following a recession. On average, analysts’ forecasts have
been almost 100% too high. This ‘positive thinking’ is also visible if one looks at
the number of buy and hold ratings in equity research departments, which
usually far outnumber sell ratings. Of course, all is easy with hindsight and next
year’s forecast is still a tough job even if we are aware of our historical errors.
...and hate doom-mongers
Even if there are positive stories circulating before crises begin, there surely are
also a few ‘realists’ who do not get carried away by the irrational exuberance of
the markets and instead give warnings before disaster strikes. Contrary to
common view, a number of respectable economists even predicted the current
crisis up to a certain point. In 2005, Prof. Raghuram Rajan presented his contro-
versial paper in the Jackson Hole Symposium titled "Has financial development
made the world riskier?”. Disappointingly, though not unexpected, Mr. Rajan was
instantly attacked by Donald Kohn, vice-chairman of the Fed, who thought the
idea was too interventionist and by Larry Summers, the former US Treasury
Secretary, who dismissed the warnings as ”misguided” (Spaventa, 2009).
Around the same time Prof. Nouriel Roubini of New York University argued that
US house prices were overvalued. Investors and home-buyers called him Dr.
Doom and instead continued to listen to Mr. Bernanke who stated in a testimony
to the US congress a year before (2005) that “at a national level [house] price
increases largely reflect strong economic fundamentals.” Even when the housing
market started to show signs of weakness in 2006, some economists did not
believe it end in a nationwide drop in prices. In a 2007 interview, Prof. Eugene
Fama, the father of the EMH, declared that “the word ‘bubble’ drives me nuts,”
and went on to explain why we can trust the housing market: “Housing markets
are less liquid, but people are very careful when they buy houses. It’s typically
the biggest investment they’re going to make, so they look around very carefully
and they compare prices. The bidding process is very detailed5
.”
5
This quote is taken from Krugman (2009).

But why do we ignore the stories that contradict our view even though it can
save us money? There are two explanations. First, Karlsson et al. (2009)
observed in their research that we suffer from what has become known as the
‘Ostrich effect’. This means we wish to avoid contradictory information as
much as possible. What’s more, when processing information to help us make a
decision, we often fall prey to a far more fundamental problem, that of
confirmation bias. This implies that we try to find new information that
confirms our own view while ignoring contradictory information. Rajan would
probably have received a standing ovation had his paper been titled “Why we
should thank regulators who made the financial markets a safer place?”. Second,
experiments show that while we assume non-rational behaviour by others, we
rule this out for ourselves. For example, when asked to rate our own driving
ability, 90% of us regularly describe ourselves as exceptionally proficient drivers
(Svenson, 1981). Evidence of this illusory superiority can also be found in our
own assessment of our intellectual abilities. Ask any portfolio manager why you
should give your money to them and s/he will probably tell you that they are
more likely to beat the benchmark than their competitors. Moore et al. (1999)
show this in an investment experiment with MBA students. The overconfidence
and false optimism of the students caused them to over predict the rise of their
portfolios.
Are we all herd animals?
According to the EMH, market prices are always right because they reflect the
independent choice (or private signals) of market participants6
. It is, in fact,
statistically proven that under conditions of independent random sampling, an
aggregate collective judgment is more accurate than individual judgments
(Surowiecki, 2004). An empirical illustration is an experiment by Treynor (1987).
The author made 56 participants make independent judgments of the number of
jelly beans in a jar (there were 850 in total). The estimate of the group as a
whole was 871, and only one of the participants made a more accurate judg-
ment. This shows that a combined judgment by a group can outperform that of
the average individual (Martin et al., 2002; Larrick and Soll, 2006). So it must
come as no surprise that individuals very often follow the ‘wisdom of the crowd’.
But the history of financial crises shows that the herd can very often head in the
wrong direction and we decide to follow them regardless. The reason, according
to behavioural experts, is that we regularly suffer from information cascades
–we make choices based on the observations of choices made by others
preceding us even if our private information differs (Smith and Sørensen, 2000).
This happens because our judgment becomes clouded when we observe the
decisions of others (i.e. our decisions are no longer independent). To appreciate
this, consider the following experiment usually conducted by psychologists:
6
Note that even if some investors behave irrationally, there will be a sufficient number of
rational participants in the market to assure that no profitable arbitrage opportunities
remain unexploited.

 A number of candidates are told that when they see an ‘apple’, they
should say it is an ‘orange’.
 Subsequently, one single candidate (A) is randomly invited into the room
without having any knowledge of the rules of the game.
 The researcher asks all candidates what they see after showing an
apple.
 When everyone replies ‘orange’ (as dictated by the researcher), very
often candidate A also says ‘orange’, even though s/he clearly sees it is
an ‘apple’.
The morale of this experiment is that we tend to find ‘safety in numbers’. Why is
this the case? An important reason is that we dislike being the only sucker
(Dawes, 1999). Portfolio managers often exhibit this behaviour since their
reward is for a large part based on relative performance (i.e. beating a bench-
mark). Thus, they are cautious to deviate from consensus because a lot is at
stake if things go awry (their bonus, promotion, job and reputation is often on
the line).
Experiments with professional equity analysts have demonstrated reputational
herding as well. In one study (Cote and Sanders, 1997), participants’ task was
to predict future returns. After each prediction, the average prediction was
shown to the participants, giving them an opportunity to adjust their own
predictions. The results showed that presenting the average prediction had a
significant conforming influence on participants’ predictions in the next round.
Note that herd behaviour plays a major role when markets shift from a period of
euphoria towards periods of excessive scepticism. As far as bubbles are concer-
ned, when the ‘bigger fool’ does not arrive, a panic is set in motion and asset
prices take a nosedive7
. Generally speaking, our panicky reaction (e.g. selling
assets at fire-sale prices, withdrawing money from a bank or refusing to rollover
debt) can ultimately result in greater losses than if we would just stay put.
The reason why we follow the herd when things turn south is due to another
factor – lack of coordination. Put simply, in the game of musical chairs, no one
wants to be the last one left standing. Everyone is individually aware that taking
action can lead to more losses than if they would stay put. But as Keynes’ noted
in his beauty contest analogy, an individual’s private information is less
important than his/her evaluation of other peoples’ expectations (also known as
higher order beliefs). Given the uncertainty concerning the latter, second-
guessing is an inferior strategy to immediate action. So when everyone starts
selling their stocks or bonds, we are better off to immediately follow suit even if
7
Once the tulip mania came to an end in the spring of 1637, tulip prices started dropping
at a rampant pace. Many of the relatively common tulips sold for no more than the price of
a common onion (Rapp, 2009).

we are sure this is unjustified given the fundamentals – this is also known as the
sell-first-ask-questions-later rule in the marketplace.
Some wonder why ‘rational’ investors do not
buy when they realise the panic is unjustified
given the fundamentals. The reason why they
cannot is because of limited collateral
(Krugman, 2009). For example, when a stock
of a company is purchased, the share price
can continue to fall and stay low for a very
long period. This can eventually force the
investor to file for bankruptcy. This is why
Keynes noted “markets can remain irrational a
lot longer than you and I can remain solvent”
(Lowenstein, 2000).
So selling amid market panic is a rational
response for everyone individually. The
collective outcome is, unfortunately, far worse
in comparison to the situation where everyone would have coordinated their
actions by deciding to stay put. Against this backdrop, any entity (bank,
company or sovereign) that is suffering from illiquidity can be forced to file for
bankruptcy if everyone believes the entity in question is insolvent (i.e. it
becomes self-fulfilling).
Does history matter?
We are not only myopic but we also have short memories (or ignorance of
history) that makes us oblivious of previous financial disasters (Galbraith,
1993). This cannot be truer than for the recent European sovereign debt crisis.
In the past decade, market participants were charging almost the same amount
to lend to Greece, Italy, Portugal, Ireland, Spain and Germany. The whole notion
of sovereign risk was deemed to be a joke in the Western world. In fact, if any-
one would speak about it a few years ago, their economic understanding, and
even possibly their sanity, would be questioned by all. Sovereign debt crisis was
a thing of the past, or so the argument went. And if it did occur, it would most
probably be in a ‘third world’ country. The simple reason was that industrialised
countries had ‘graduated’ from periodic bouts of government insolvency given
that they did not opt for a default since the 1960s (see figure 9). Thus, the
entire history of sovereign default, which goes back at least to the fourth
century B.C. when 10 out of 13 Greek municipalities in the Attic Maritime
Association defaulted on loans to the Delos Temple (Winkler, 1933), was deemed
irrelevant. So was the fact that governments in most advanced countries had
defaulted on numerous occasions on their domestic and foreign-owned debt in
the past 200 years (see figure 10).
Figure 9: Sovereign defaults are nothing new
0
5
10
15
20
25
30
35
40
45
0
5
10
15
20
25
30
35
40
45
Proportion of countries that experienced a sovereign default
of which advanced economies
Sovereign default on both domestic and external debt

But then the moment of truth arrived. Financial markets found out in November
2009 that the Greek government had “cooked the books” (Pisani-Ferry et al.,
2010). The announcement of authorities in Dubai, around the same time, that
they wished to postpone the repayment of their bonds, further concentrated
investors’ minds. All of a sudden, bond vigilantes woke up to the fact that all this
time they had been suffering from what Reinhart and Rogoff (2010b) call the
this-time-is-different syndrome –the belief that financial crises are
something that happens to other (emerging) countries at other times because
the industrialised countries have the right policies, have learned from their past
mistakes, and are built on sound fundamentals. We now realise that public debt
of the industrialised countries is not as safe and ‘special’ as some cheerleaders
had been arguing. Against this backdrop, default probabilities that were hovering
around zero before the crisis, have now shut up to 30%-75% in some of the
European countries (see figure 11). What was perceived as unimaginable
(sovereign default in the West) has suddenly become imaginable.
Once again, behavioural economists are not surprised by this outcome. Glaser et
al. (2004) have shown that risk perception is particularly susceptible to
overconfidence. We usually believe that our abilities are above average
(Svenson, 1981), may have an illusion of control (Langer, 1975), may be
excessively optimistic about the future (Weinstein, 1980), or may think our
knowledge is more accurate than it really is (Lichtenstein et al., 1982). As a
result of our overconfidence, we are prone to underestimate the actual risks (i.e.
ignore historical lessons) and overestimate our abilities to overcome unforeseen
problems (March and Shapira, 1987). This was perhaps the reason why
European financial regulators and governments thought before the crisis that
there was nothing wrong, and if there was, they could easily solve the problem.
What’s more, market participants were overconfident in the ability of govern-
ments and regulators in taking control of a given situation (even though history
Figure 10: Some governments defaulted more Figure 11: Sovereign default probabilities
Source: Reinhart and Rogoff (2010), Rabobank Source: Reuters EcoWin, Bloomberg, Rabobank

has shown that this is rarely the case). Against this backdrop, most investors
decided to have blind faith in ‘efficient markets’ and ‘capable’ authorities instead
of doing their own homework.
Overall, when we are overconfident we always believe, for some reason or
another, that history no longer applies to the present situation. When asset
prices rise, we try to explain it by fundamentals. When banks become too large
(with respect to a country’s GDP), we explain it through globalization of finance.
When countries live beyond their means (i.e. run a massive current account
deficit), we think the reason is higher growth potential (i.e. higher return)8
. And
when reality smacks us in the face, we come to realise that all this time we were
dreaming. Unfortunately, as soon as the next boom starts rolling, historic
lessons become forgotten again and the similar arguments will be presented.
Key takeaways
Asset bubbles and financial crises have been with mankind for centuries because
we do not act like homo economicus. Indeed, as Krugman (2009) notes “many
real-world investors bear little resemblance to the cool calculators of efficient-
market theory: they’re all too subject to herd behavior, to bouts of irrational
exuberance and unwarranted panic”. But given the huge human and financial
costs associated with these crises, everyone wants to find ways to prevent them.
But that is wishful thinking at best, and dangerous at worst since under such
illusion we will be overly exposed to the new and unexpected (Black Swans –
Taleb, 2007). In fact, in his Nobel-prize acceptance lecture, Hayek (1974)
warned us about this pretense-of-knowledge syndrome by stating: “To act
on the belief that we possess the knowledge and the power which enable us to
shape the process of society entirely to our liking, knowledge which in fact we do
not possess, is likely to make us do much harm.”
Overall, behavioural economists have shown throughout the years that as long
as we behave like we do (i.e. like humans), financial crises will always be with
us. This is because we
 do not have limitless knowledge and information. Even Noble
prizewinning economists have trouble understanding the economy’s
complex system. The collapse of LTCM with two Nobel laureates in
economics on its board (Robert Merton and Myron Scholes) serves as a
good example. Similarly, portfolio managers can never have complete
knowledge of all the stocks and bonds available in the world. Since we
face an information overload in the world (aggravated by the internet),
we become very selective with the information we acquire. And given
the confidence we have in our own ability, we are more likely to
selectively seek information that confirms our own view.
 are by nature optimistic, overconfident and greedy. Everyone loves
8
This was, for example, the rationale for sending money to the Latin American, Eastern
European and Asian countries in the past until everything blew up.

to hear a success story. That is why those who have lost tons of money
are usually not invited to cocktail parties. This is just human nature.
‘Positive thinking’, overconfidence and greed are the reasons why we
have achieved so much. Without these attributes we could not fly in an
airplane, let alone land on the moon. As Gordon Gekko, the fictional
character in the movie ‘Wall Street’ famously proclaimed: “Greed, for
lack of a better word, is good. Greed clarifies, cuts through, and
captures the essence of the evolutionary spirit.” Yet we must stress that
overconfidence and greed, especially in the financial markets, have also
shown their uglier side time and again. These attributes can be so
powerful that they make us myopic, with short memories and an
ignorance of history. Hence, we must appreciate that overconfidence
and greed can sometimes push us towards great inventions while other
times they can cause great suffering.
 hate to be the only suckers. When everyone is getting rich, we
usually get sucked in as we do not like to fall behind. Studies have
shown that our well-being is not determined by our absolute income, but
rather by our relative income. Our social standing in a community is
extremely important. At the same time, when everyone panics and
rushes for the exit, we usually panic and do the same even if we are not
sure of the reason. An important reason is that we do not want to be the
only one suffering from losses. As such, we tend to follow the herd even
if the herd heads in the wrong direction (either in period of excessive
optimism or pessimism).
So we should be under no illusion that we will ever prevent asset bubbles and
financial crises from taking place. They will be with us as long as we roam on
this planet. But there are certainly ways to fight them. Contrary to conventional
wisdom, the best way is not through monetary policy or heavier financial
regulation (although they might slightly help). To solve a problem, one has to
find its root-cause. If humans bring about crises, then learning about our own
psyche can be the most effective tool to fight crises. This means adding courses
like finance, psychology and economic history to high school curriculums can
prove to be very helpful. As for those who have already graduated from school,
receiving training in these fields should be a must regardless of profession. At
the end of the day, we need such knowledge for taking economic risks9
.
Hopefully, an increase in our ‘knowledge’ will help us understand that
 the world economy is a large complex, dynamic and unstable
system. One day people are optimistic about the future and they buy
houses, cars, and other durables, while consuming more luxury services,
such as visiting restaurants and going on vacation. And then the next
day confidence vanishes in a puff of smoke for one reason or another.
This can exert enough downward pressure on asset prices to cause a
financial crisis. Therefore, before taking economic risks, we should be
9
We take economic risks when taking a loan, purchasing an asset or even accepting a job.

aware that one or more factors can suddenly turn something that
seemed profitable/sustainable today into something unprofitable/unsus-
tainable tomorrow10
. This is why the most sophisticated banks,
regulators and rating agencies have difficulty predicting crises and
crashes. So uncertainty concerning the future will remain with us
forever.
 history matters! Quite often history repeats itself (albeit not exactly in
the same way) but we tend to ignore it because we think it is useful
information for historians only. That is plain wrong! A better appreciation
of our past makes us aware that paradigm shifts do not happen
frequently. Against this backdrop, we should be aware that asset prices
do not always go up even if they have been rising for an extended
period. Being constantly on the lookout is a far more profitable strategy
(i.e. valuations should never be ignored).
 there is no return without risk. We must understand that whenever a
return is made on anything (even government bonds), there is risk
involved. Risk-free return simply isn’t.
These lessons will, with a bit of luck, help us reduce the frequency and severity
of asset bubbles and financial crises. The key is coming to terms with the fact
that we are boundedly rational (Simon, 1956, 1982). In other words, we need
to understand that some situations exceed our capacity to judge probabilities
and make good decisions. Isaac Newton, the famous physicist, painfully learned
this after losing ₤20,000 (more than a million dollars in today’s money) in the
South Sea bubble. He stated afterwards: “I can calculate the motions of
heavenly bodies, but not the madness of people”.
10
This is what economists mean by multiple (Nash) equilibria

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