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9 October 2017

How Richard Thaler’s behavioural economics changed finance after the 2008 crash

Not so long ago, you were assumed to be rational enough to take out a mortgage without even proving your income. 

By Julia Rampen

Trade shows are generally dreary gatherings where you collect free pens from booths in return for sharing your business card. But back in the heady days before 2008, one company operating in the mortgage industry had a different idea. Attendees were encouraged to drop their business cards into a box. When enough cards had been collected, one would be drawn out – and the winner would get a private show with a stripper. 

This was one of the many stories I heard as a journalist reporting on the mortgage market in 2013, a time when almost all my contacts had first-hand memories of the crash (others included a fight on a yacht in Dubai). I also heard stories about friendships, affairs, overwork and bankruptcy. The mortgage market, it turned out, was not merely comprised of a set of balance sheets, but a group of people. When I reported on other markets, I found the same thing. 

Today, the idea that human failings override financial logic is everywhere – mainly thanks to the influence of Richard Thaler, who co-authored the 2008 book Nudge and has this week won a Nobel prize for his work on behavioural economics. In 2010, the Coalition government established the Behavioural Insights Team, to try out some of his recommendations. If you were automatically enrolled into a pension, or will one day receive an organ donation because people now have to opt out rather than choose to become donors, then you too are experiencing Thaler’s theories made real. 

Thaler’s underlying argument is that humans do not act as rationally and predictably as economists expect. In the mid-Noughties, this observation was not as obvious as you might think. New Labour had embraced “light touch” regulation of the financial services (although deregulation started in the “big bang” under Margaret Thatcher).

The idea that the customer could surf this wave unaided was represented in concepts such as the “self-cert” mortgage, which allowed individuals to borrow without proving their income. Economics degrees sidelined the history of previous financial bubbles in favour of neoclassical quantitative models (and continued to be taught even as the financial markets went into freefall). 

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Books like Nudge (co-authored with Cass Sunstein) punctured the conceptual bubble. Regulation has returned. Today a mortgage adviser will ask you to think about possible changes in your life, and to imagine what you’d do if interest rates rose. Mortgage lenders scrutinise your behaviour, from spontaneous spending to choosing a fancy car over a more affordable one

But Thaler’s insights went deeper than mortgage borrowers. In 2008, two months after the collapse of Lehman Brothers, Thaler wrote in the Financial Times that: “Many economists have argued that even if individual consumers suffer from bounded rationality, markets will be set right by specialists who can figure out even the most complex problem. But… even these sophisticated investors got things badly wrong.”

He pointed to the way banks had sliced up mortgage risk and repackaged it in mortgage-backed securities as an example of complexity that engulfed financial institutions as well as borrowers. 

In the mid-Noughties, the booming mortgage market attracted talented businessmen, honest brokers and crooks. Those still operating in the post-crash market were generally among the smarter and wiser set – and less likely to be swayed by a trade show stripper. All the same, even the smartest and wisest person in a market sometimes makes mistakes, and they may not realise the consequences. As the financial crisis fades into memory, Thaler’s insights are more relevant than ever.