it has changed enormously over my professional lifetime and I venture to predict that as a result of the current crisis it will change even more over the coming decade economists of my generation were brought up we were water up to believe that we should analyze economies in terms of as if atomistic maximizing individuals who only interact through market prices as if we were all anonymously playing economics games in front of computer screens neither the intensity of our preferences our emotions nor our beliefs counted for anything of course we knew the world was not like that but the role of economics was to see how far we could push on this atomistic egoistical hypothesis gary becker who was meet milton friedman's successor at chicago is the best example exemplar of this approach that's claimed I don't know whether it's true that on the day that his wife informed him that she proposed to divorce him he penned an article on the economics of divorce one one can distinguish between the different social science disciplines either on the basis of the methodology that they adopt or on the basis of the phenomena they study economists wanted it both ways we wanted the phenomena regarded as part of economic life to be studied on the basis of this maximizing methodology it doesn't work beliefs and emotions matter for economic decisions as George Akerlof showed us very clearly yesterday concepts of fairness enter all labor market decisions but fairness fairness cannot be explained in terms of individual maximization rational maximization has not proved a good way of understanding investors portfolio decisions and there are numerous other examples where now all behavioral economists and economics is now a behavioural subject and so we're honored here to have with us one of the main exponents of modern behavioral economics how people actually behave which differs from the behavior of these abstract computer autonomy matters for economic decisions and outcomes well the English and French as everyone knows have been at war for seven hundred years and this also extends to economics though not for seven hundred years but I remember Frank on when I was a student remarking that apropos of Malan Ville there's no french economist had ever understood keynes we English proved up pride ourselves on being pragmatic the French of Cartesian that's all right in practice but what about the theory is the remark of the French civil servant American universities draw on all the talents and in fact that's the one of their major strengths and none more so than Princeton we're all on been abou is professor it's a pleasure for me to introduce law who is a French intellectual who writes a beautiful English and who poses analytically questions which the English would perhaps prefer to leave for discursive after than a discussion over the port it's a great pleasure okay thank you very much for such a nice introduction it's a pleasure to be here is there a way that these slides can be projected door okay great thank you all right thank you I like to stand up hopefully you can still hear me so I'm going to talk about the formation and persistence of collective or social beliefs and particularly interesting for economists who usually think of individuals as rational calculators as was just we were just reminded of are the beliefs involves some form of reality distortion or as psychologists would call it cognitive dissonance or dissonance reduction and in the economic realm those seem to be relevant in many in many aspects organizational overconfidence contagious market exuberance particularly in asset markets thank you political ideologies culture religion and I will mostly talk about the first three or only the first two if I run out of time and I borrow the term groupthink from Janice who as a political scientist or political psychologist who studied episodes of foreign policymaking and this identified or claimed to have identified eight symptoms of what he called groupthink which are listed for you here illusion of invulnerability collective rationalization belief in inherent morality etc which leads organizations of different types to generally bad decisions there any bad outcomes and it's summarized in the dictionary as a pattern of thought so we want to understand how people think especially when they're together characterized by self-deception forced manufacture of consent consent and conformity to view group values and ethics now to go right into an example I'm going to talk first about ideology and give you some examples so let's take a nice neutral question that we can all agree on such as the free enterprise and free market economy is the best system on which to base the future of the world so do you strongly disagree somewhat disagree somewhat agree strongly agree I think I have a kind of feeling for what the answers would be in this room but in general answers differ widely both within a country and across countries and this is the result of a poll where I think about 10 or 20,000 people where we're pulled in each country and you can see first of all that around the average degree of let's say support or belief in markets which is the blue bar the average for the whole sample at the bottom is 61% we have a wide dispersion and some countries are where you would expect them in the u.s. 71 percent of respondents agree that free markets and free enterprise are likely to be the best solution to the problem of the world interestingly China which is in the towards the bottom there's even more support for markets that's a recent phenomenon at the other extreme we have Russia we're only 43 percent of the people endorse markets and even more extreme we have friends my country were only 36 percent of the people believe in markets now these are the beliefs that people state when they're just you know asked about it what's the importance of what they believe or say they believe well here we can look at little correlation between the extent of support for markets or belief in markets which is what we just looked at and that's what's along the horizontal axis going to the rights are more stronger market beliefs and the extent of state intervention in the economy measured by share of taxes and GDP and basically what you can see is that you know in countries where people are more likely to respond that they believe in markets the government is smaller relative to the economy and vice-versa in countries where it's the reverse you can do that with other indicators this is an indicator of labor market regulation and perhaps not surprisingly where people believe in markets Canada US Great Britain etc there's little regulation of the labor markets where people don't believe like France and over there Turkey there's much more so one way to look at this is to say well you know democracy works or political pressure work to the extent that people like or dislike markets that's what's going to be delivered by the political system another story which is maybe the worrisome is to say well where do these beliefs come from and how can people in today's world believe such different things about how the world works and perhaps there is something in the other direction that people it's not just that people get what they like or what they believe in but they start liking or believe in what they get or what they're stuck with so the Cazale could be going in both ways and that's what I'm going to be arguing in this talk more generally there's a whole set of beliefs that are economically important that concern theories of the world and that differ widely across country so we've seen the relative merits of the state and the market there's also role of effort versus luck in life outcome why are some people rich others poor Trust which was which is also a plays a big part in this in this conference festival religion culture these are all beliefs which vary across countries are correlated strongly with policy vary across individuals and are correlated with how people vote interestingly each group or country thinks it has the truth and not just for itself but everybody would be well inspired to imitate them and you know you can think also about religion not surprisingly not everybody can be right so it's not difficult to find evidence that shows that these beliefs are inconsistent with the data and yet they persist a kind of collective mistake which sometimes can be beneficial we can think of you know good morale the audacity of hope' or things like that or we can think of disastrous errors here's a couple more example this is the belief that determines income more attribution to luck as you go to the right and social spending as a percent of GDP again you see that where people think it's all about luck they want to redistribute where if where they think it's about efforts and talent they don't want to redistribute another belief I mentioned is religion average reported importance of God in a person's life over there the USA at one extreme at the other Sweden and Denmark Italy somewhere in the middle the more people report believing in God the less social spending there is and again the question is you know which drives which so let's kind of go from this big picture to a smaller picture because it's always in a more you should always start you know looking at problems at small problems because bigger ones let's think about organizations like firms or government bureaucracies etc here also we see occasionally strange beliefs with bad consequences so in the aftermath of corporate disasters you can think of Enron things like that they're often there's a word that comes back all the time which is red flags and there were many there are often many red flags which people ignored rationalized or did not want to see and this goes along with a certain discourse or rationale we're better than you know this time is different we're a smarter we have better computers better tools and so on similarly when people engage in in fraud or what we economists would call moral hazard it's often just regular people who find ways of justifying to themselves the unethical things that they do whereas in other aspects of their life they're perfectly good people so self ception is important there as well example of disastrous wishful thinking and really denial in organizations we have the Challenger and Columbia space shuttle disasters on which extended reports were written which document the extent to which people did not want to look at the evidence I'll give some examples similarly the Securities and Exchange Commission in the US and probably know the country's was caught in a similar kind of willful blindness and we could say also the Fed finally we can think about or next we can think about markets where a lot of individual participants get caught in some kind of frenzy or some irrational exuberance and think that the price of this or that is going to keep going up and they make investments based on that and eventually it collapses and again this goes along with strange rationale such as this is a new era we need new measures for valuing firms and so on so some elements of psychology such as over optimism wishful thinking etc seem relevant to understand this not relevant that's not the only thing that's relevant standard economics is also relevant what's important is the interaction of the two the interaction of incentives markets and so on with the fact that people very often invest in their beliefs and treat them kind of protectively either because it makes them feel better less afraid of the future or sometimes it helps them function more effectively and I'm going to focus mostly on the effective value and the emotional value of these beliefs so the rest of the talk is going to organize let's say going from small or to larger units I'm going to talk about realism and denial in small groups like corporations or government units then financial markets and then if there is time I'll talk about social beliefs about the states and the market status and less affair and the way I'm going to proceed is kind of give examples mostly through kind of quotations and things like that of what seems to be the role of collective illusions in each of these phenomena and then I'll try to sketch how economists think about this or try to conceptualize the interaction between individual psychology and collective interactions in the markets in a bureaucracy and so on and the type of results that this can lead to okay so let's think first about organization a firm would be the obvious example Bank but it costs to be a government unit and let me start briefly by reviewing some or presenting let's say some findings of investigations or just sometimes some quotation from from reports in the media that alert us to the I to the to the possibility that people may not be fully rational in the usual sense at least in processing information in looking at evidence that they might want to see certain things and not other so this is from the report on the one of those Space Shuttle designers the one that burns because it lost some protective tiles and the report emphasizes that the managers resisted information in particular they were they refused to get pictures of the damage to assess whether it would be whether it was a fatal damage or just a minor maintenance issue they had basically as indicated here decided in advance what the state of the world was what the reality was and since they knew what reality was they didn't need to look at evidence and they didn't want to look at evidence similarly in the extensive no books that have been written on an ROM again there was a lot of malfeasance there but there's also blindness in particular by the CEO who not only lost a lot of money in the end he died but he at the same time as he was kind of cynical in some ways he was also very he had his head in the sand in many other ways and got burned financially even before the company got bankrupt bear stearns CEO James Kane had six percent of the stock was a multi-billionaire during the whole crisis reportedly he was away playing golf and bridge at a professional level all the time and a few weeks or months later he had lost his billions and just had a few meager millions left another example another pattern is what's called normalization of deviance that is something happens an anomaly a dangerous signal that should cause you to pause and and stop and take things carefully but since it didn't blow up the whole thing it didn't blow up the space shuttle in this instance then you say then in fact it's normal that these things should happen and as they start happening more and more frequently then you worry about them less and less whereas you should be worrying about them more and more but the rationality is well so far it hasn't blown up and you can see evidence or parallels to that also in the financial sector so evidence that the design was not performing as expected was reinterpreted as acceptable and non deviant which diminished perceptions of risk anomalies that did not lead to catastrophic failure were treated as a source of valid engineering data that justified further flight you could just change the words to you know securities and investments and and you have there you have it regulators I think we're also I mean they were subject to some political pressures but they were also a bit blind or at least unwilling to look at the evidence in the inspector general reports on how bears on how the Securities and Exchange Commission dealt with the problems at Bear Sterns again this word comes back new aware of numerous potential red flags what did they do in response to those red flags nothing they did not take actions to limit these risk factors and they did not even look more closely they had only a very small number of people to examine the whole industry and they hadn't completed a single inspection by the time the crisis had had hit at the Fed it's the same thing one of the one of the inside people a Federal Reserve governor warren alan greenspan about the you know the coming or potential problems with subprime mortgages he was not asking that he put a stop to it but that they investigate the potential dangers and he was rebuffed similarly the office of the control of the currency prohibited those agencies that they'd want to investigate that they'd want to look for evidence from doing so so again this pattern of not wanting to see and the examples I use here are from the US but I'm quite sure we could find some from other countries last example is from foreign-policy having to do with Iraq this is a very nice quotation from a journalist who interviewed a top White House official and was told that guys like him were in what I called a reality-based community which he defined as people who believe that solutions emerge from your judicious study discernible reality so the journalist nodded I thought it was a good thing and murmured something about alignment enlightenment principles and empiricism but he had it all wrong that's not the way the world really works anymore continued the official we're an empire now and when we act we create our own reality so we don't need to study reality in evidence and while you or us are studying that reality judiciously we'll act again creating other new realities which you can study too and that's how things will sort out we're history's actors etc okay so in some sense that's what I want to do here he was partially right I want to study people who think that they can create their own reality this is a little cartoon I don't know if you can see the caption or if it's been part of your translations these ostriches around the stable are sitting around the table and the president says the motion has been made and seconded that we stick our heads in the sand so collective delusions is what I'm about so now let me move from kind of you know informal evidence to kind of a sketch of how we can think about that so let's think of an organization a firm for instance where participants the workers in the firm can at you know choose to work hard or not work hard towards the objectives of the firm or people can invest money also in a project and you know whether this pays off or not it's going to be revealed only in long run a few years from now let's say and it can be success or failure you can become very rich or you can lose it all your pension your job maybe go to jail if it was illegal and that all depends on what other people are doing because we're in a group are they working hard are they investing are they making good deals bad deals and whether the whole enterprise is a worthwhile one it's a sound product that we're selling or not are these is the market in which we're investing strong or weak and so on is the shuttle you know are these owing problems minor or major and so on so that's the kind of standard economic part of the point of the of the problem and then there are emotions or feelings what are called anticipatory feelings we as humans always project ourselves in the future and then we either worry or we rejoice depending on whether we think the future is going to be grim or Pleasant so if it looks like the firm project is on a right track and riches await us and so on then we feel good we're happy and and maybe even we might be more productive if we're scared that things are starting to look shaky that the company might go down that what we're doing might be revealed to be illegal etc then we have stress we you know can't sleep at night we fight with our spouses we get ulcers and so on and that's all unpleasant so beliefs about the future become something that we consume something that we that affects our well-being from day to day and not just objective information the way we usually treat them as economists but something that you care about directly given that we have to think about how what should I believe then so beliefs are formed by combination of standards economic or cognitive objective cognitive process an emotional more psychological one we can see that say in the company how things are doing does the CEO look like he knows what he's doing or does he look insane does their is there you know are people saying that there's a bubble in the housing market or not where the engineers saying about the shuttle so we get some signals and the question is not just in form but what do you do with this information in particular when it's scary information when it suggests that the future add rather than what you had for so we have a choice conscious or unconscious as to acknowledge and deal with bad news in particular or look away miss Reed for yet and so on there's a trade-off there if I don't pay attention or I rationalize the way good bad news and I feel better but on the other hand it's gonna be dangerous so I just summarized news with a green flag which says things are all clear you can keep working can keep investing and most likely you'll be successful or red flag which says wait a minute things are not the way you thought it's getting dangerous maybe the the project will generate lawsuit the interest what do people do when they see famous red so there are two basics things you can do one is I'll call real you call a green flag a green a red flag a red flag and when there's a red flag you stop and think and you know limit your losses and stand that the great wreath red flag wasn't really red it was kind of greenish and you know or raising the red flags they always red flags so let's not pay attention to them and let's go ahead as if it was green so you engage in you know self selection and self-deception rationalization and so on you treat the innovation in a biased kind of way of course we can do some of both be partially realistic partially in denial and the trade-off is the one that I mentioned more denial makes you you know makes this short-term more pleasant the future looks more rosy on the other hand I have to pay for it down the line so to eff these effective benefits of putting on rosy glasses these two women are walking down the street and one sister the other I'm doing a lot better now that I'm back in denial but what happens on the line that's another question so let's try to capture this trade-off with a very simple representation of you know how people deal with bad news so you suppose that there is a red suppose suppose there's a red flag that has been raised excuse me and are you going to acknowledge it and be realistic you can be realistic you know with a hundred percent that's what the one stands for and that's what you know standard economic agents would would do or if you go to the other extreme if you're very susceptible to hope fear and wishful thinking you can be a zero percent realist and whenever they're bad news you put your head in the sand or you pretend that the red was green and you can kind of locate yourself or people you know or politicians you know you know along this graph to see how they deal with bad news anywhere from full realism to fold an aisle to somewhere in between now the question so this is what the individual this is basic individual psychology and everybody will differ on where they are you know in this in this graph now the question is now that we're all interacting we're all working at Enron or we're all working at Bear Stearns or we're all working for the government you know how does our willingness to put our head in the sand depend on whether other people also have their head in the sand or are making you know considerate objective and coal coal decisions objective decisions there are two cases that that we can think of one good and one bad the good one is when the collective illusion corresponds to what you might call group morale and morale is you know it's a good thing for example for sports team or for a company it's good to have high morale to think that you can you know to some extent succeed even though the things look bad right now so this is a case when given that they're bad news maybe so that is the project doesn't have such a high return it's not worth my while to work hard in it to put more money in it etc but I'm happy if others remain extremely optimistic and they put more money in it they do more of these deals similarly in a sports team if I know that we have a small chance of winning maybe I'm not going to run hard and try to score because it's I could get injured and I know we have a low chance of winning but I'm perfectly happy if my teammates keep the high morale if they don't want to hear about how much better the other team is they're increasing our chance of winning and I'm not paying the cost so this is a case where when someone else or other people around me are deluded or in denial about the the you know the fact that who are not in the best of all possible words this is good for me I benefit from other people's denial so when there's a red flag but then and other people don't want to see the red flag and they keep a high morale and that's good for me then the red flag isn't as threatening to me because it's being partially compensated for by the strong morale that my teammates or coworkers are keeping and therefore reality is not as scary so in this little chart that shows you how different people who have different degrees of susceptibility to hope fear etc how much realistic they are when they go from when one of these people goes from being surrounded by realists to being surrounded by people who are in denial of the form that I just mentioned who keep a high morale and that's good for them they become more willing to accept reality they become more of a realist so as more other people become less realists I become more of a realist the other case which is more interesting is what I call the groupthink and that's typically when there's very high stakes to the project so in the good in you know in the good scenario the green flag scenario we all get rich or I get rich in the bad scenario things get really ugly and in particular if people he don't pay attention to the red flag if they keep setting up you know either dubious or illegal or highly leveraged deals that could blow up the company and lose me my job lose me my pension then buy their delusion they are now hurting me and they're making a bad reality worse so if I was slightly afraid of reality now I'm a much more afraid of the coming train wreck which has been worsened by other people's blindness so this is the case where the denial of others makes a bad reality even worse even more fearful and so I'm more inclined now to join them with my head in the sand as we go from being surrounded by realists to being surrounded by people in denial who can't you know stop for red lights and are imposing greater risks going to also join them in denial so this is what I call the mutually assured delusion or mad principle that is and it's very perverse it says when reality avoidance call it good morale is beneficial when you'd like more of it it's not contagious the more people have it the less I love it III have conversely where it's detrimental when it creases creates more risk for every that's when it spreads that's when it reinforces each other it reinforces itself across people so where people in an organization are going to be thinking about reality in ways are introduced interdependent and particularly in the second way and they're going to tend to all think of reality in the same way and that is in particular if others don't want to see red flags it's a chance that I also don't want to see them so it's kind of a depressing result so this mad principle for mutual you trust sure destruction maybe should be renamed the mad off principle because people do show a willingness to ignore red flags and this is one of the best examples of people including very sophisticated individual investors and companies you know putting money in this twenty fifteen to ten twelve to fifteen percent guaranteed return on your money based on some secret undisclosed strategy etc and we know the end so let me just skip that because I'm running out of time and give you what comes out of the of this will exercise the same organization or similar organizations can have a culture of realism or in the bad case a culture of denial where bad news we look away from them in the case where denial is a bad thing so that's why it's perverse that's why it's mutually-assured delusion and destructions all persist in the court in that case everybody persists in the wrong course of action because they're afraid of acknowledging reality and the reason the reality is so frightening is because other people are ignoring red flags and increasing the risks that we all face when is it likely that we are caught up in this bad group think when we're very dependent on each other when your mistakes damage me a lot and my mistakes damage you a lot and there's no way no easy way I can get out when the project is very risky that is in a good case we all get very rich in the bad case it's terrible for all of us and these are typical of new technologies high financial leverage high pain centers and so on we can also think about organizations at high year XI are hierarchies some people are more important than others and and the same intuition tells me tells us that I'm going to adapt my way of thinking to the way of thinking of the people whose decisions and therefore whose beliefs realism or denial have the greatest impact on whether it's my paycheck my pension my welfare in general ok so my outcome depends on whether the company's project is good or bad that is we've had good news a green flag or red flag but also on how the stats say the manager deals with a case where there's a red flag so if there's a red flag and the manager stops and is careful losses are going to be limited for him and for us the workers on the other hand if the managers or management charges ahead ignoring all red flags keeps investing more opening new factories taking more risk then we're going to bear some of those consequences that we might lose our job we might lose our pension and so on so this idea that our beliefs our way of seeing the world is interdependent and in particular that the direction is one from those who have the most impact to those who have the less impact we can think of a simple hierarchy that say person one is the manager person two is the worker or many workers that's one example but we could also think about you know a marriage a husband and a wife and the case that's interesting is when one person's delusions are very damaging to the other but not the reverse so in my case it was the manager in that scenario this same mad principle predicts that it's the man in this case the workers are going to adapt the way of seeing the world of the manager so I you can look you can ignore that little graph and just look at those bubbles or those bullet points up there if the boss is a realist deals realistically with bad news that's what's happened on the left side of the graph the subordinates will also be facing willing to face bad news because the damage is limited the manager is a realist on the other hand if the manager or the captain of the ship is in denial and it's going to take us to a disaster and there's not much I can do then it's more tempting to finally reasons why maybe he might know what he's doing after all so the lesson here is that subordinates adapt their vision of the world to that of their boss and beliefs are going to trickle down the hierarchy whether its realism or delusion okay now how could you counteract this damaging groupthink in the case where it's bad I've said sometimes it's good if we are in kind of a sports team type of interaction well if it's group morale then you don't want to limit the extent to which people are overly optimistic in fact you want to encourage it you want to encourage group morale you want people to be slightly over optimistic and we see how coaches or sometimes employers try to anova stir the morale of their players or their workers in the case of groupthink what you need is somebody to break the illusion you need somebody to dig up the red flag that nobody was willing to look at and stick it in everybody's face and force them in some sense to deal with reality but that's very difficult it required so we would like somebody to you know take our head out of the sand when we stick it in the sand but when we're very afraid we really don't want to take the head out of the sand so there's a commitment problem here if there's a we would like to put in place Cassandra's who repeats warning signals who you know alert us to the dangers that we might be inclined to look away from but when the danger is there and the and they are pointing our attention to it we don't want to see it okay so that's why it's not so easy to limit these type of group things phenomena groupthink phenomena and that is also a way to understand role of institutions such as in the political area arena constitutional guarantees for free speech Free Press more generally institutions that protects or even encourage dissent including in corporations devil's advocates whistleblower protection laws etc these are ways of committing ourselves to the truth even though we know that when the bad news hit we won't know we won't want to face the truth but we have to find a way of forcing ourselves to see it and we have to protect the casandra's and it may or may not be so easy to do let me move on now to market interactions because that's kind of a current topic so the story here is going to be the very very similar but it's going to be instead of some interaction between how people in the company think how they deal with reality it's going to be about investors how they think and how they deal with reality so again a few examples of the potential relevance of collective delusions rationalizations etc to what we have seen in the last couple of years excessive certainty it's hard for us without being flippant to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions that's a strong statement made by the manager of AIG s financial London unit which blew up the company by taking bets on hundreds of billions of credit default swaps let's look at Lehman an investor asked so this was kind of already way into the crisis an investor asked this chief financial officer why they were not raising capital like Citigroup and Merrill this was a really bad question to ask the CEO glared that the questioner and say they didn't need more after all and the proof was they still had to post a loss so you know we get into this idea that if I don't want to recognize a loss then there is no loss the company had industry veterans in the executive suite who had perfected the science of risk management she said we know when we need to be worried and when we don't alan greenspan was asked in congressional testimony whether he was at all concern that if one of these huge institutions that I just mentioned fail to have a horrendous impact on the national and global economy no I'm not I believe that the general growth in large institutions have occurred in the context of an underlying structure of markets which makes many of the in which many of the larger risks are dramatically dramatically was not strong enough I should say fully hedged fully insured and so again it's a sure thing there's no risk another rationale that I mentioned before is this time is different okay we're circumstances previous circumstances or not do not apply we have a wealth of information we didn't have before we understand the data and can price that risk this was countrywide I don't think it's a bubble said chief or for the Carlyle Group so if it's not a bubble what is it what's happening now is that people are beginning to use a different investment technique called private equity which adds real value so as usual you know there is some truth to a potential truth to these statements but there's also at least I feel a degree of delusion especially since these are the arguments you hear every time there's a bubble every time there is a kind of investment frenzy let's talk about housing and subprime mortgages so United Capital Asset Management which no longer exists was you know putting out a lot of them and the chief executive thought that the consumer has to be an idiot to take on those loans because they'll never be able to repay nonetheless he was selling a lot of them of these mortgage-backed securities and one one of his best performing investments until of course things went south and the four of the fund first lost a lot of money and then closed it was bankrupt so now let me try to think to do the same kind of little um semi-formal exercise of thinking about how individual investors psychology you will interact with economic forces in this case an asset market like the housing market or the hog market market for housing for mortgage-backed securities internet startups etc to generate a potential wave of irrational exuberance that will lead to over investment and then a crash so let's think of a market that operates in the form following wave there's a first round of investment when a new technology or new financial instrument appears and you can individual investors can get in start investing if they want okay and in general you know this is at least initially this promising so people get in then we get some news about market prospects future demand etc or whether people will be able or not able to repay their mortgages so again we get a red flag or green flag and red flag might be more and more people talking about the presence of a bubble in the housing markets or the fact that consumers have taken on unsustainable levels that etc etc investors both individual investors and institutional investors now have to deal with these news with these kind of scary news they're scary because you already have some of these things in your portfolio based on the fact initially it looked good and so you can be realistic in which came you become a bear or you remain bullish you dismiss the bad news you dismiss the casandra's and you engage in some degree of denial I'm excessively simplifying here of course it's never completely black-and-white then after that once you've processed the news we can either keep investing by you know if you're somebody who's buying houses and trying to flip condos you can buy more of those and borrow more if you're somebody who is buying mortgage or a bank that's putting mortgage-backed securities on this balance sheet you can buy more of them etc etc you can escalate or stop and if you have remained bullish inspired red flags you'll escalate if you've chosen realism you're less likely to escalate and you will stop and then finally the market delivers its verdict demand is confronted with supply people either can pay or cannot pay the mortgages and so on and the price ends up being high or low and that generates gains or losses depending on the positions that people had okay and the price will be high or low depending on two things first of all how much people have invested the more supply the more houses the more houses have been built the low world the price of housing B the more of these more of these securities have been issued the lower their price will be etc so the total supply if you want in both rounds of investment will depress the price and on the other hand you know there is demand which could be high or low or some other state of uncertainty which is what we're learning about with these red or green flags just to make the point that so in the meantime okay just as before until the market delivers its ultimate verdict we live with fear or hope of you know rags and riches and so on and so we might have an incentive to engage in motivated thinking of the kind that I've described in particular that's true if the assets and questions are not very liquid don't have a market in which there is an objective price from that from the first day okay and what I want to show here is that this was indeed the case for these mortgage-backed securities so these are the balance sheet of Lehman Brothers and Bear Stearns I think around to 6:00 or 2007 in billions and assets are just are divided in three levels level one or assets that trade in active markets with readily available prices so it's hard to deceive either others or yourself about a level one asset because the price is printed in the paper you know every day or even more often than that but for these two those were only between 35% and 70% of their assets or was invested in level 2 assets which are called mark to model so there is not a liquid market for these assets you have to you know run a statistical model and make some assumptions about what they're worth so there's more degree of freedom to get or to believe what you want to believe and those were 56% at Lehman and 74% at their Stern's level three assets there's not even a model that you could use to figure out what the price is instead the price that is used quote reflects management's best estimate of what market participants would use in pricing the acids so it's basically management's best guess 8% at Lehman 18% sorry 8% also at Bear Sterns and my point is you know with these assets again you can put a price that will you know it deceive your investors but that's dangerous you could be prosecuted for that but it's also very easy to de-seed yourself that these things are worth more than they actually are similarly credit default swaps worldwide the market was about 50 trillion yep very good that's about 50 trillion but there is no single well operating market where you can go and sell your credit default swap and immediately find a buyer and there's an objective price it's all bilateral transactions is so these assets CVS's as well as the other things that these banks had on their balance sheets correspond to what I was kind of representing here in this stylized way it's some investment you make and you won't know what the price will the objective price will be for a while in the meantime you have to live with the uncertainty and you have some degree of flexibility or ambiguity in what you should expect about the price the final price whether it's going to be high or low so now again the question is exuberance by which I mean people do not pay attention to red X and just assume that the price of housing keep rising or that you know certain securities will always keep paying off does the fact that other people are exuberant does that become contagious does that make me individual investor or the individual bank less or more likely to become also exuberant and to just forge ahead with more of these assets so there are two effects here of the blindness of other investors to let's say warning signals of an of trouble ahead the first one so if other people other investors are irrationally exuberant let's use that phrase they will keep investing by building more houses putting more of these securities on their balance sheet and the and then in the end there's gonna be a glut on the market and the price will be not just slow but very very low we're again in this situation where the blindness of others hurts everybody because it's going to further depress the price that these assets are worth now if I have seen a red flag if I have some feeling that other people are not paying attention I should expect that there's going to be a lot of our investment and that the final price will be very low on one hand this should make me be cautious say well if I don't pay attention again this is not necessarily all conscious but if I don't net if I don't pay attention to the red flag if I dismiss it if I remain bullish I'm going to buy more of these assets or build more of this of these houses and I'm gonna make losses on that on those extra investments and those losses will be even larger due to the fact that other people are over investing and the market is going to collapse so this argues for caution on the other hand even if I don't invest more I've already invested I'm already in this market I already have some of these securities on my balance sheets hundreds of billions of them or I already own houses or condos and these are not so liquid I can't get rid of them very easily for the reasons that we've seen or or to the extent that we've seen therefore I'm going to make if we are indeed in the red flag situation I'm going to make losses on the investments that are already made and it may be hard to recognize or to to others to my let's say shareholders but also to myself or my wife that I'm going to make those losses and those losses are made larger by the fact that everybody has invested too much and that the market is going to collapse so if this reality worsening effect which is you know related to the mutually assured destruction delusion idea dominates then the more people over invest out of irrational exuberance the greater will be my incentive to over invest out of irrational exuberance and this will become contagious and we will have a market mania so you need two things you need that we enter the situation in which bad news arrive with market positions they're large enough we've build up sufficient inventory because things initially looked good and that these assets be relatively illiquid under those two conditions if things work out fine the market will be realistic and stop when it sees a red flag but it's equally likely that it will ignore the red flag and that will be caught in this wave of over optimism and excessive investment so the market mania will be contagious we'll have over investment and an eventual crash let me skip what I was going to talk about ideology in the interest of time because of unless there are some questions on this I want us to end with five main kind of results this general idea that's denial is like a disease it's contagious when it hurts and when you don't want it to spread is when it's spread and when it's good then when we call it morale is when it precisely when it doesn't spread enough that collective realism and collective wishful thinking can take hold and persist in firms organizations governments etc especially if they start at the top they will trickle down that in order to counter that we need some constitutional protection for this or even encouragement of dissent whether in the political area arena or in the corporate or organizational arena market manias and crashes work very much in the same way so again we need some things that will force us to to look at unpleasant evidence and then this is what I will not talk about the same thing applies for beliefs about you know whether markets are good or governments are good the kind of things I will showed you at the beginning and you can have again the same types of collective delusions with some countries believing excessively in the virtues of the market and lack of regulation in other countries believing excessively in all the good things that the state can do and that public intervention can do and again we have to be we have to recognize the fact that these collective delusions arise from individual psychological traits are basically innate or very hard to change and what we need are some institutions particularly having to do with you know forcing us to look at the truth in order to prevent these cases of collective blindness thank you very much thank you very much Rollo are there people with microphones okay someone got microphones to pass well you bother I enjoyed that very much I just like to ask the hold of this presentation up on our website because I cut you short and I think people would like to see the ideology aspect of that mask you were you would you locate in your modular scheme mr. Chuck Prince former CEO of City who famously declared in July or August 2007 as long as the music goes on one has to step up and dance I don't know what's going to happen when the music stops month later he was thrown out of City because of the losses she was clearly referring I quoted the Chuck Prince I may quote Jerome Kerviel or whoever you like people who go on playing so they are well something is not right simply because the others are still dancing right so I think if I understand your question correctly you know it's a combination of that's a cynicism that reflects shows the incentives that that that they face the pressure to generate high returns because everybody is currently generating high returns together with some excessive optimism I think that you'll be the one who can you know stop and get the chair before the other is that you won't be the one left holding the hot potato and Citigroup was not you know not as badly hurt as the others like Lehman Bear Stearns but in the end they got hurt a lot in particular due to second round of investments that they did later on they bought some of these trouble companies and then they inherited those troubles and paid down the line the price of his excessive optimism so I think you know its feet it seems to fit reasonably well the story that I was trying to tell I wonder do you know the paper the working papers by Phillips whoo and you and Phillips and you are rolling bubbles and how do they relate to what Phillips and you have argued that what we've seen is a sequence of bubbles which have rolled through the economy starting with Nasdaq and rolling through subprime oil etc so one bubble follows and others investors when they get out of one fall for the next delusion no I don't know that paper but but I think you know the idea sounds right and and both for example Bob Shiller in his book on irrational exuberance and Shiller and George Akerlof in their book on animal spirits you know talk about how there are these you know throughout history and they're now many books on this particular aspect you know these cycles of excessive hope and then despair repeat themselves because the human psychology is unchanged and the instruments that we have at our disposal to give it to leverage it in some sense and and have it have larger and larger consequences keep getting more and more sophisticated a question immediately behind these were Yale working papers incidentally a couple of months ago I was saying we've been experiencing a lot of bubbles so in the end someone should learn about it and is there a scope for learning in your model or you mean that humans are able to decide not to learn after there so I mean the real question is whether the scope for work for learning in the real world and I think there's a there is a limited scope for learning I don't have it here but actually there's a there's a nice quote from Alan Greenspan again after the I think was after the internet bubble where he said explicitly that there had been a surprising extent oh no actually it was actually the wave of corporate scandals earlier than that there had been you know a lot of malfeasance that we needed to put in but and that we knew it now but people have a tendency to forget and that we needed to put in place regulations so that it wouldn't happen again and then you know the next bubble came and he actually argued against regulation and so he himself in some sense forgot the lessons of history I think so I think we can't rely on individual psychology or on our limited cognitive abilities to to to remember always the lessons of history were fallible plus it will be a new generation next time etc so what we need are kind of institutions with long memories both in terms of you know how we structure financial markets or other you know corporate law etc and also I think you know things like the the press and and the media they don't always have long memories but at least you know they they can keep a record of what's happened and that can help us collectively not forget now we have two questions here one and then a little bit further forward for italiana la demand a possibility momentous ooh okay these people simply brought to a mental hospital and take responsibility for what they've done a statement a statement by Calisto Tanzi said I had a delusion of Ganta I was not aware what I was doing and none of my family helped me I read that a couple of days ago don't you think that they all these people may be acquitted for what they've done simply on the basis of alleged mental impairment so I quotation but I'd be interested to to read it and to have it I think it's so I don't know the particular case I think it's probably understandable that his family didn't help him look at things realistically because to the extent that they themselves had high stakes and things you know going well and and and and not ending the way they did so if you're if you're benefiting from something that is dangerous that's when you and you will be very hurt if it collapses that's when you don't want to see the dangers and I think most likely you know his family also had benefits from from the operation in terms of you mentioned people like him I think that we have to be careful not to not to to treat people who are caught up in these collective by the way very often ways of overconfidence or or delusion as pathological cases I think we all have these tendencies and it's just a matter of the incentives that you face and whether they will lead you or not to to engage in these kinds of delusions I don't know that I don't think it should you know absolve from legal responsibility especially if there was there were illegal acts but I don't think we can with some exceptions perhaps you know Bernard Madoff is an exception I think we all have we could all be in that situation I think given the right situation and given the right incentives that's why it's so dangerous yeah I'm sure Parmalat conforms exactly to your story actually Parmalat was financing Palmer it financed the football club everybody empowerment you that there were questions you shouldn't ask about Parmalat his question I'm thinking that compared to other work you know most most work on bubbles emphasize false beliefs but your model seems to identify an additional factor having to do with preferences having to do with people liking to be optimistic and these and liking to be optimistic it seems to be good in some cases it generates you know more effort and it seems bad in other cases so but are you suggesting that maybe we should think very carefully about what what personality traits we match with what positions in our society where should we not have optimists so let me answer the question in two parts and the first part is maybe more of an economists conversation I think most models of bubbles and things like that we have do not emphasize false beliefs if you think of standard rational stochastic bubbles people are doing exactly the right thing they know the risk they're taking they're not under any delusion even if you think of what are called informational cascades or hurting models people are just looking for more information and they they follow the crowd because it's likely that the crowd has more information if they had a brother-in-law who was a statistician and they asked their brother-in-law what should I do to have more information given this is the way the market operates the brother-in-law would agree that they should follow the crowd so these are these are not kids so on the one hand we have these that's a historical or sociological accounts of bubbles manias crises etcetera which are full of stories about people telling themselves that it's this time is different we're smarter I can get out before the other is etc which were all about delusion and the economic models that we have so far they are they are useful they capture important aspects but they don't have these aspects of delusion and in order to understand why people might engage in bias processing of evidence you have to understand the psychology the motivations behind it the fear the anxiety the hope for riches you could call it greed if you want but again this is something we all have the competitiveness so that's the first part I think I think these emotional this interaction between emotional or individual psychology and bubbles etc has not been adequately captured before secondly I think matching psychological traits to positions I think yes you know that's hard to that's that may be hard to do but the point is the same traits that might be very good in one organization or at one stage of the organization can become very dangerous so for example people who create a company entrepreneurs are very often people who you know have no self doubt who think that they can they can do whatever you know whatever they set their mind to they have they are typically extremely self-confident and their self confidence its contagious and this is a good thing maybe too at the stage when you need to motivate your workers to raise capital etc but later on when you are let's say running a big company then you have access to financial leverage that your actions start affecting other market participants this can become very dangerous so I think indeed the traits that we all have different degrees of let's say susceptibility to wishful thinking to over optimism etc and to the extent that it's possible it would be good if people were matched with either jobs or phases of the company or phases of the organization that in which those traits are valuable in terms of morale rather than dangerous in terms of contagious and detrimental overconfidence other questions I'm impressed by the heterogeneity of investors net generality of different types of investors I have friends who made quite a lot of money over the last two years hedge funds have been much maligned but have generally participated I think in a positive way over the current crisis over the recent crisis and many of them by short selling into bubbles and correctly short selling into bubbles they've come in for a lot of stick for that it seems to me that the good macro hedge funds pride themselves on integrity integrity of judgment and that has proved valuable so in a sense a market responds to what you're saying is well this just makes this just gives the stage to the smart guys who can see when things are not fundamentally based and who do are prepared we've got the pockets to take the to take the long view I'm being deliberately provocative yes so I think you know this is this is related was saying before if there's someone or some organization that actually benefits from other people's excessive optimism this person organization will not be induced to join in but they will behave very cynically it's when they're kind of prisoner of the other people's excessive optimism that they want to basically join in and I think there is a role for short-sellers you can even though you know it might not be very popular but you can think of them as these Cassandra's that accept they're you know they're doing it for the money but by their actions you know they are raising again the red flag in a very visible way that's this company this sector whatever is headed for losses rather than gains so I think there is they there is definitely a role for that the evidence shows that you know it's not sufficient and in fact short selling is only a very small fraction of I think something like 2% of all of all because of various reasons so I don't think we can rely just on that and certainly we can't relied on the fact that they pride themselves on their integrity because everybody prides themselves on their integrity questions or shall we adjourn George you want to say something I'll just comment about this short selling that the short selling may establish a market in which will give the prices the things are gonna look like in the future so it may be maybe even if you had to have just a few short sellers I think that was my what what I was looking at it when I looked as if I was going to ask a question but again I'm not I'm not advocating advocating the short selling is I believe your story there any other questions before I say I think this has been a very exciting presentation I've learnt a lot I'm I anybody who's worked in financial markets nobody who's worked in financial markets believes the efficient market hypothesis otherwise nobody could make money and we knew that a long time ago from Grossman and stigmas so we have to believe that behavior and beliefs matter and some those of us who lived in New York or London have sufficiently many friends who've made lots of money from the failure of efficient markets from actually being able to outsmart the markets to know that behavior and and beliefs really do matter and these stories which as I said before were for me stories which my friends would tell over dinner about how people would be believing silly things and so forth to see a model of this is a very exciting for me I enjoyed it enormously thank you very much well thank you