Bankers' Brains, Market Behavior

Rationally directed greed would never have led us to this financial crisis. People are not nearly as rational as the market evangelists in the Republican Party would have us think.
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This week's version of John McCain -- the populist version -- is blaming our current, um, situation on greed. (With such strong fundamentals in our economy, we couldn't call it a crisis.)

Last week's John McCain, and the one from the week before that, and the week before that, and the one who has served in the Senate for two decades, would not have been so negative about greed. As a fan of free markets, this long-standing version of McCain believed that greed pushed markets forward, causing people to take the kind of risks that propel economic innovation. The new McCain pretends that he believes markets are flawed because they encourage greed. The old McCain would have seen today's banking debacle as a rational market correction to a decade of generous monetary policy from the Federal Reserve.

The old McCain was wrong to have such unfettered faith in markets. People are not nearly as rational as the market evangelists in the Republican Party would have us think.

But the new McCain, the one who insincerely blames our banking crisis on greed, is equally wrong. Rationally directed greed would never have led us to this crisis. Greed alone is not the cause of recent business failures. Trust me, the former directors of Fannie Mae and Freddie Mac are not jovially counting their earnings and laughing at us taxpayers for providing them with generous severance packages. The leaders of AIG and Lehman Brothers are not congratulating themselves for raking in the dough while running their companies into the ground. (That said, I think any solution to this problem should involve large paybacks from these extremely wealthy people.)

Both the old McCain and the new one don't realize much more fundamental limitations of human nature that, when combined with unfettered markets, are a recipe for disaster. Let me illustrate one of these limits, a strange kind of herd mentality that infects our species, by asking you to imagine a situation that most of you will never be in.

You are a medical student, spending a month on your OB/GYN rotation, learning how to deliver babies and how to take care of female reproductive health. You're spending the morning in the operating room, and the head surgeon has just finished prepping a patient. The patient is now anesthetized and the surgeon looks your way and says: "Hey student, come over here and feel this pelvic mass." The surgeon is asking you to perform a pelvic examination on this woman, so you will be better at recognizing abnormal masses when you examine future patients. But you are concerned -- you've never met this woman before, and you realize that you would be probing her most private parts without her permission, offering her no benefit at all. You would simply be practicing on her anesthetized body. What would you do?

When non-physicians are asked to consider the scenario, they say they wouldn't feel right about examining this woman without her permission. Indeed, people entering medical school feel strongly that it is important to ask for such permission. But in my research, I have discovered that graduating medical students frequently feel that such permission is not necessary. In fact, they experience a significant shift in their opinions shortly after completing their OB/GYN rotations.

Why do students' views change so much? Because they learn through example. They come to respect the surgeons conducting their training, and learn that the surgeons are generally good people -- motivated to help patients and to teach students. So when respected surgeons invite them to conduct these pelvic examinations, their moral concerns clash with their opinion of the surgeons. Ultimately, many students reconcile this clash by becoming less concerned about the morality of examining women without their consent.

What do pelvic exams have in common with our banking crisis?

I expect that in the last few years, many financiers looked around and saw their peers taking on increasingly risky mortgages. Their rational sides worried that such practices were unacceptably risky. But honestly, who can calculate the exact risks of such practices? They knew that their peers were very smart. They recognized that the institutions their peers were working at were historically cautious. So they followed suit. Meanwhile, their peers glanced back in their direction, and came to the same conclusion.

People are often prey to social norms and peer pressure. We often judge our own behavior by comparing it to the people around us. Sometimes our rational instincts compete with these herd instincts, and in such cases the herd instincts often win.

What neither the old McCain nor the new McCain recognize is that free markets, for all their wonders, can be disastrous when left unfettered to compete with the irrational side of human nature.

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