It’s a bubble’s effects that are hard to predict

One of the benign side effects of the credit crunch has been the boom in popular awareness of behavioural economics – a discipline that brings psychological insights to bear on economic theory. Behavioural economics books, such as Nudge and Predictably Irrational, have sold well and become influential. That is partly because they are good books, but it is also because a superficial reading of both behavioural economics and the credit crunch can lead to the same conclusion: people are crazy.

Yet, while popular awareness of behavioural economics was overdue, the links between irrational behaviour and the credit crunch are more subtle than they first appear. To see this, one need only re-read the behavioural economics books published before the crisis became severe. Nudge has a section on subprime mortgages, but it focuses on consumer protection. Predictably Irrational is being revised in the light of the credit crunch, but the first edition took a similar line, focusing on the vulnerability of naïve consumers. It does not seem to have occurred to the behavioural economists – even after they had seen the first glimmerings of the credit crunch in 2007 – that the banks would need protecting from themselves. The thought did not occur to many other economists, either.

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