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dadmonson

How much of a role did cognitive bias play in the global financial crisis?

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I know next to nothing about the global financial crisis and I am just now learning about cognitive bias.  This was a homework question. How would you answer this question? 

Here is what I'm going to say:

"Cognitive bias could have played a huge role in the financial crisis but only because of government involvement.  If people were free to make mistakes because of cognitive bias, then only those people who made the mistakes would suffer, not the whole nation."

 

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Your answer is is sketchy. Also, the second sentence goes beyond the question. You need to start by listing a few different actors in the crisis: perhaps, government officials, bankers, businessmen, individual shareholders, etc. Then you need to think about the different types of cognitive biases and ask how they can be found in the behaviors of these actors. Then, frame that into an answer.

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6 hours ago, softwareNerd said:

Your answer is is sketchy. Also, the second sentence goes beyond the question. You need to start by listing a few different actors in the crisis: perhaps, government officials, bankers, businessmen, individual shareholders, etc. Then you need to think about the different types of cognitive biases and ask how they can be found in the behaviors of these actors. Then, frame that into an answer.

Thanks for the reply but I don't think I have adequate information in order to do what you said.  I went on ahead and gave an answer similar to the one in the op.

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You could write a couple of thousand words on that question. More even. I would interpret the question as asking what extent was the financial crises a result of irrationality.

The financial crisis certainly was not just a result of government involvement. Snerd is right, you would need to research a much broader range of factors to give an objective well-reasoned answer.

I'm not sure what level you are studying at, but these resources might be of interest to you:

http://people.duke.edu/~dandan/Papers/PI/CA.pdf

The above is a paper identifies how people can arrive at an initial price somewhat arbitrarily - but that variations in prices between comparibles is rational - so for example something of better quality will be valued higer, which is objective, but the initial price is arbitrary. It's a good paper to get you thinking.

Miller wrote articles about "Irrational Exuberance" - might be worth looking up some of that.

Miller's articles/books will give you a feel for the sort of academic thinking around irrationality.

The Rational Markets Hypothesis rests on a premise of easy access to good information as well, so information assymetry may be another aspect to consider. People act on the information they possess - if there is a problem with this then it can lead to people trying to act as rationally as possible but still making the wrong choices. 

You have to consider that we do not live in a fully capitalist system - instead it is a mixed economy. So perhaps you could break it down and focus on those two aspects (planned and free), contrasting them and exploring the dynamics at work.

 

Edited by Jon Southall

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The architectural company I was working for in 2008 was deeply impacted by the collapse of the multi-family residential (condominium) market.  As fast as we were putting them up, they were being bought - and the prices skyrocketed, instead of going down as one might suspect.  Developers were coming to us with proformas of around $180/sf and projected sales at $300 to 450/sf.

I believe that this was due to all the cheap money coming out of Washington, brought on largely by money the government was spending on the war in Iraq and Afghanistan, deficit "stimulus" money after 9/11, and the encouragement of cheap, government insured mortgages.

An adjustment had to be made in the real estate market prices - it could not sustain itself.

However, I remember saying to myself, sometime around the summer of 2008, that the "news" from DC that some type of "bail out" plan was being worked on will only draw out the recession.

In my opinion, if the banks and mortgage companies had just bit the bullet and refinanced loans, then the adjustment would have been painful, but not unbearable.  But many companies were hoping to get money from DC in lieu of doing this (which they ultimately did).  Same for the US automakers, but to a lesser extent.  They wanted cash from the US to fund the union pensions (which they got).

 

 

Edited by New Buddha

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