2012), Psychology and the financial crisis of 2007-2008

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. 1 Yale School of Management. This essay is in preparation for Financial Innovation and Crisis (MIT Press, Michael Haliassos, ed.). It is based on an invited talk at a conference in 2009 on the occasion of the awarding of the Deutsche Bank Prize in Financial Economics to Robert Shiller. I am grateful to Malcol