Psychology and the Financial Crisis of 2007-2008

Abstract:     
I discuss some ways in which ideas from psychology may be helpful for thinking about the financial crisis of 2007-2008. I focus on three aspects of the crisis: the surge in house prices in the years leading up to 2006; the large positions in subprime-linked securities that many banks had accumulated by 2007; and the dramatic decline in value of many risky asset classes during the crisis period. I review a number of psychology-based mechanisms, but emphasize two, both of which have already been extensively studied in behavioral finance and behavioral economics: over-extrapolation of past price changes; and belief manipulation.

Number of Pages in PDF File: 16

Keywords: financial crisis, psychology, extrapolation, belief manipulation

JEL Classification: G12, G21

working papers series