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Hope, Greed And Fear: The Psychology Behind The Financial Crisis-II

The language of psychology helps to address the fact that behind every cut-and-dried statistic about falling home prices and other indicators of economic decline lies an ever-shifting horde of homeowners, bankers, business owners and unwitting investors -- in short, people.

Poor Self-Control

Duckworth defined self-control as the ability to negotiate a situation in which there are two choices and one is obviously superior, but the other choice is nevertheless more tempting. For example, a dieter faced with a chocolate cake knows that it is best not to eat it, but often makes a choice to eat it anyway. In the case of the housing bubble, homebuyers failed to exercise self-control when they bought larger homes than they knew they could afford. Lenders failed to exercise self-control when they chose to write shaky mortgages in order to bank short-term profits.

For years, Americans have saved less and consumed more, Duckworth said. She pointed to the conclusion of a recent editorial in The Wall Street Journal by Chapman University research associate Steven Gjerstand and Chapman University economics professor and 2002 Nobel Laureate Vernon L. Smith: "A financial crisis that originates in consumer debt, especially in consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge," the editorial stated.

Added Duckworth: "It seems that my father was right during those conversations around the dinner table when he would say, 'Americans are living beyond their means.' I guess we were. And I think that's in part because all human beings want to live beyond their means."

Self-control is an aptitude that changes dramatically over a lifetime, according to Duckworth. This is because the prefrontal cortex, the area of the brain that allows human beings to control impulses and delay gratification, matures more slowly than other parts of the brain. "Sub cortical regions and the brain stem are more or less online as soon as you're born, if not very soon after ... so emotion and impulse in these areas are functioning at full throttle" right away, she said. But the prefrontal cortex is not fully developed until a person is much older -- somewhere in the late 20s and possibly as late as the early 50s.

Delaying Desire Gratification

"There's a lag problem here, where we have our emotions and we have our impulses ... but you have to wait until you're at least 25 before the frontal cortex is in great shape to actually rein in those lower-level desires."

Studies by psychologist Walter Mischel that measure how well a preschool child could delay gratification (asking the child to choose between eating one marshmallow now or getting two later) predicted a range of outcomes that happened later in life, from SAT scores to divorce to use of crack cocaine, Duckworth noted. "I think that these almost unbelievable findings are in fact believable, because Walter Mischel was able to distill in a simple testing situation the classic human dilemma that we all face every day, which is: more later, or a little bit now?"

These and later studies on delayed gratification have shown that self-discipline is a bigger predictor of later success than other factors such as I.Q., Duckworth stated. A better understanding of the psychology of self-control could help "develop government policies that would presumably accommodate the realities of human nature."

A Question Of Trust

"What happens when the bubble breaks, as it inevitably does?" Herring asked. The pendulum swings back to the other extreme. "People find it all too easy to imagine that bad things can happen to the market and they withdraw. And they tend to overshoot. They will act very, very risk averse for quite a long time until they are persuaded that [real estate] is once again a safe asset to hold."

According to David M. Sachs, a training and supervision analyst at the Psychoanalytic Center of Philadelphia, the crisis today is not one of confidence, but one of trust. "Abusive financial practices were unchecked by personal moral controls that prohibit individual criminal behavior, as in the case of [Bernard] Madoff, and by complex financial manipulations, as in the case of AIG." The public, expecting to be protected from such abuse, has suffered a trauma of loss similar to that after 9/11. "Normal expectations of what is safe and dependable were abruptly shattered," Sachs noted. "As is typical of post-traumatic states, planning for the future could not be based on old assumptions about what is safe and what is dangerous. A radical reversal of how to be gratified occurred."

People now feel more gratified saving money than spending it, Sachs suggested. They have trouble trusting promises from the government because they feel the government has let them down.

‘Bad Things Happen To Good People’

He framed his argument with a fictional patient named Betty Q. Public, a librarian with two teenage children and a husband, John, who had recently lost his job. "She felt betrayed because she and her husband had invested conservatively and were double-crossed by dishonest, greedy businessmen, and now she distrusted the government that had failed to protect them from corporate dishonesty. Not only that, but she had little trust in things turning around soon enough to enable her and her husband to accomplish their previous goals.

"By no means a sophisticated economist she knew that some people had become fantastically wealthy by misusing other people's money -- hers included," Sachs said. "In short, John and Betty had done everything right and were being punished, while the dishonest people were going unpunished."

Helping an individual recover from a traumatic experience provides a useful analogy for understanding how to help the economy recover from its own traumatic experience, Sachs pointed out. The public will need to "hold the perpetrators of the economic disaster responsible and take what actions they can to prevent them from harming the economy again." In addition, the public will have to see proof that government and business leaders can behave responsibly before they will trust them again, he argued.

"Once a person has been traumatized, promises ... are experienced as dangerous -- not safe -- because they require trust to believe," said Sachs. "It is up to the victim to decide when she can trust again. This takes time."

Courtesy: Knowledge@Wharton



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