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A Crisis of Beliefs: Investor Psychology and Financial Fragility
How investor expectations move markets and the economy
The collapse of Lehman Brothers in September 2008 caught markets and regulators by surprise. Although the government rushed to rescue other financial institutions from a similar fate after Lehman, it could not prevent the deepest recession in postwar history. A Crisis of Beliefs makes us rethink the financial crisis and the nature of economic risk. In this authoritative and comprehensive book, two of today's most insightful economists reveal how our beliefs shape financial markets, lead to expansions of credit and leverage, and expose the economy to major risks.
Nicola Gennaioli and Andrei Shleifer carefully walk readers through the unraveling of Lehman Brothers and the ensuing meltdown of the US financial system, and then present new evidence to illustrate the destabilizing role played by the beliefs of home buyers, investors, and regulators. Using the latest research in psychology and behavioral economics, they present a new theory of belief formation that explains why the financial crisis came as such a shock to so many people--and how financial and economic instability persist.
A must-read for anyone seeking insights into financial markets, A Crisis of Beliefs shows how even the smartest market participants and regulators did not fully appreciate the extent of economic risk, and offers a new framework for understanding today's unpredictable financial waters.
The collapse of Lehman Brothers in September 2008 caught markets and regulators by surprise. Although the government rushed to rescue other financial institutions from a similar fate after Lehman, it could not prevent the deepest recession in postwar history. A Crisis of Beliefs makes us rethink the financial crisis and the nature of economic risk. In this authoritative and comprehensive book, two of today's most insightful economists reveal how our beliefs shape financial markets, lead to expansions of credit and leverage, and expose the economy to major risks.
Nicola Gennaioli and Andrei Shleifer carefully walk readers through the unraveling of Lehman Brothers and the ensuing meltdown of the US financial system, and then present new evidence to illustrate the destabilizing role played by the beliefs of home buyers, investors, and regulators. Using the latest research in psychology and behavioral economics, they present a new theory of belief formation that explains why the financial crisis came as such a shock to so many people--and how financial and economic instability persist.
A must-read for anyone seeking insights into financial markets, A Crisis of Beliefs shows how even the smartest market participants and regulators did not fully appreciate the extent of economic risk, and offers a new framework for understanding today's unpredictable financial waters.
264 pages, Hardcover
First published January 1, 2018
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Displaying 1 - 13 of 13 reviews
July 6, 2019
This is both highly academic and esoteric and also obvious. I agree with the thesis of the book, but I don't think it's as revolutionary as they seem to think. But perhaps they are talking to other macroeconomists who always seem to be confused when their models based on perfect rationality don't work out
November 12, 2018
Standard economic theory is a very elegant and internally consistent body of mathematics that aims to explain human behavior. This “colossus” has however recently succumbed, in the authors’ words, to a series of “daring and effective hit-and-run attacks,” (p. 140) both from mainstream economists (with co-author Andrei Shleifer very much at the forefront) but also from the currently fashionable field of behavioral Economics. The 2008 financial crisis, which the theory struggles to explain, was rather inconvenient as well. Perhaps a coup de grace, even.
A theory is not dead, however, until you have another one to put in its place. Even then, in the words of Gunnar Myrdal, “in Economics, all doctrines live persistently; no new theories ever supplant the old.” That’s where “a Crisis of Beliefs” comes in.
“A Crisis of Beliefs” is a bold first attempt to broaden the foundations of the field by layering it on top of the imperfect judgement and behavior of humans. After first motivating the discussion by summarizing their previous work on Neglected Risk and its potential role in the crisis of 2008, Gennaioli and Shleifer introduce the concept of Diagnostic Beliefs, which humans form based on the behavioral heuristic of Representativeness, an idea due to rock star psychologists Tversky and Kahneman. Rational Expectations are but a special case of “Diagnostic Beliefs” and therefore do fit within this framework.
To make a long story short, Representativeness is the heuristic whereby because (at 10% of the Irish population) red-haired people are ten times more prevalent among the Irish than they are among all Caucasians (of whom they are but 1%), the moment we see somebody with red hair we (mistakenly, if you do the math) presume they must be Irish. Applied to the observation of past investment returns, it plays havoc with future investment decisions, the small print on all investment advisories notwithstanding.
The math is easy to follow, and that’s a good thing: Economics may not yet be tangled in String Theory, but if you don’t know your stochastic calculus and your differential geometry you can’t get an advanced degree in the subject any longer. This is a return to the times when you could get a Nobel for something as elegant as the Capital Asset Pricing Model: I read the whole thing in the tube. Proofs, for the less trusting, are to be found in the Appendix.
The summary is as follows: if we accept that Representativeness is a decent approximation for the heuristic along which investment decisions are made, then we can build a model for the economy where investment cycles are built-in from the start: output that turns out to be higher than expected will lead us to overinvest in the next cycle; but our expectations from that next round are likelier than not to be frustrated, because they were founded on the unrealistic heuristic of Representativeness, which now kicks in the other way. And so on.
It’s very very elegant. I’m not sure it works with asset markets as well as it works for investment in the real economy and I’ve no idea how I’d implement it in continuous time, but it works as advertised.
Personally, I’d like to see an economist model Chuck Prince’s brain when he explained that “when the music’s playing you’ve got to get up and dance,” because I’m reasonably convinced that’s precisely the human trait that keeps us in the game even when we know we’re malinvesting: it’s our competitors for the house in the good school district that we’re fighting, not the housing market itself.
But that takes nothing away from what is guaranteed to be a classic. Buy and read it now, so you can tell your kids one day you were there from ground zero.
A theory is not dead, however, until you have another one to put in its place. Even then, in the words of Gunnar Myrdal, “in Economics, all doctrines live persistently; no new theories ever supplant the old.” That’s where “a Crisis of Beliefs” comes in.
“A Crisis of Beliefs” is a bold first attempt to broaden the foundations of the field by layering it on top of the imperfect judgement and behavior of humans. After first motivating the discussion by summarizing their previous work on Neglected Risk and its potential role in the crisis of 2008, Gennaioli and Shleifer introduce the concept of Diagnostic Beliefs, which humans form based on the behavioral heuristic of Representativeness, an idea due to rock star psychologists Tversky and Kahneman. Rational Expectations are but a special case of “Diagnostic Beliefs” and therefore do fit within this framework.
To make a long story short, Representativeness is the heuristic whereby because (at 10% of the Irish population) red-haired people are ten times more prevalent among the Irish than they are among all Caucasians (of whom they are but 1%), the moment we see somebody with red hair we (mistakenly, if you do the math) presume they must be Irish. Applied to the observation of past investment returns, it plays havoc with future investment decisions, the small print on all investment advisories notwithstanding.
The math is easy to follow, and that’s a good thing: Economics may not yet be tangled in String Theory, but if you don’t know your stochastic calculus and your differential geometry you can’t get an advanced degree in the subject any longer. This is a return to the times when you could get a Nobel for something as elegant as the Capital Asset Pricing Model: I read the whole thing in the tube. Proofs, for the less trusting, are to be found in the Appendix.
The summary is as follows: if we accept that Representativeness is a decent approximation for the heuristic along which investment decisions are made, then we can build a model for the economy where investment cycles are built-in from the start: output that turns out to be higher than expected will lead us to overinvest in the next cycle; but our expectations from that next round are likelier than not to be frustrated, because they were founded on the unrealistic heuristic of Representativeness, which now kicks in the other way. And so on.
It’s very very elegant. I’m not sure it works with asset markets as well as it works for investment in the real economy and I’ve no idea how I’d implement it in continuous time, but it works as advertised.
Personally, I’d like to see an economist model Chuck Prince’s brain when he explained that “when the music’s playing you’ve got to get up and dance,” because I’m reasonably convinced that’s precisely the human trait that keeps us in the game even when we know we’re malinvesting: it’s our competitors for the house in the good school district that we’re fighting, not the housing market itself.
But that takes nothing away from what is guaranteed to be a classic. Buy and read it now, so you can tell your kids one day you were there from ground zero.
December 25, 2018
I picked this up because Financial Times called it one of the Best Books of 2018. They noted it is "a book written for academics, but of wider relevance". It is indeed written for academics, which is the primary reason for my low rating. I'm not usually put off by "academic" books but I think that many readers will struggle with this one.
This book takes what is, I think to many normal people, a very common sense idea and is trying to give it a rigorous mathematical & theoretical backing. This book, much like Andrew Lo's recent Adaptive Markets, have a similar motivating goal: it isn't enough to just complain about the failures of neo-classical economics, the Efficient Markets Hypothesis, or the Rational Expectations Hypothesis. You need to tie it all together into a cohesive theory. "Only a theory can beat a theory". In this case, the theory that the authors have developed (over a series of academic papers) is "diagnostic expectations". (In a review of the book, Arnold Kling suggests that "recency-biased expectations" would be a better, but still imperfect, name.)
A Crisis of Beliefs starts with the observation that people often overreact or underreact to news. This is Kahneman & Tversky's "representativeness heuristic"; when we start considering buying a new convertible, suddenly we notice lots of convertibles on the road around us that we had never paid attention to before. In their timeline they are focused on the underreaction of the failing housing market in early 2007 and then the subsequent overreaction to the failure of Lehman. But how do you take that simple observation, ground it in micro-foundations, make a convincing case that survey beliefs map to the real world, tie those micro-foundations to macroeconomics, make it a testable hypothesis, and have mathematical proofs so it isn't all just handwaving?
And that's where -- while it is interesting to academics -- I think many lay readers will lose their interest. Because they just aren't really that interested in all the ground work necessary to turn something into a Real Theory™. Most readers will, I think, be able to read the introduction, the first chapter, and possibly the concluding chapter, and take away 90% of the book's relevance for them.
Ultimately, while I am intrigued by the book I think that most readers should skip the book length treatment & find a shorter article on the same topic of "diagnostic expectations". If you google looking for reviews of the book, you'll find many examples that are suitable.
This book takes what is, I think to many normal people, a very common sense idea and is trying to give it a rigorous mathematical & theoretical backing. This book, much like Andrew Lo's recent Adaptive Markets, have a similar motivating goal: it isn't enough to just complain about the failures of neo-classical economics, the Efficient Markets Hypothesis, or the Rational Expectations Hypothesis. You need to tie it all together into a cohesive theory. "Only a theory can beat a theory". In this case, the theory that the authors have developed (over a series of academic papers) is "diagnostic expectations". (In a review of the book, Arnold Kling suggests that "recency-biased expectations" would be a better, but still imperfect, name.)
A Crisis of Beliefs starts with the observation that people often overreact or underreact to news. This is Kahneman & Tversky's "representativeness heuristic"; when we start considering buying a new convertible, suddenly we notice lots of convertibles on the road around us that we had never paid attention to before. In their timeline they are focused on the underreaction of the failing housing market in early 2007 and then the subsequent overreaction to the failure of Lehman. But how do you take that simple observation, ground it in micro-foundations, make a convincing case that survey beliefs map to the real world, tie those micro-foundations to macroeconomics, make it a testable hypothesis, and have mathematical proofs so it isn't all just handwaving?
And that's where -- while it is interesting to academics -- I think many lay readers will lose their interest. Because they just aren't really that interested in all the ground work necessary to turn something into a Real Theory™. Most readers will, I think, be able to read the introduction, the first chapter, and possibly the concluding chapter, and take away 90% of the book's relevance for them.
Ultimately, while I am intrigued by the book I think that most readers should skip the book length treatment & find a shorter article on the same topic of "diagnostic expectations". If you google looking for reviews of the book, you'll find many examples that are suitable.
May 10, 2021
This book was a fun intellectual challenge to engage with a much more rigorous form of behavioural economics than I have previously been exposed to. As the authors state, this book is meant to provide a widely applicable, relevant and empirically tested theory to explain the actions of economic agents. The authors were helpful in distilling key contemporary economic research in this area to a more accessible level. In addition, the authors are very open regarding their thought processes that went into constructing the framework for the book. For the most part this was highly effective in creating a coherent arc explaining why their model is important and accurate. However, at times, this rehashing of the overall structure seemed over-repetition. One of the main highlights of the book was the mathematical rigour. This provided a refreshing challenge, to think through how the different qualitative discussions of the authors would translate into quantitative modelling. Overall, this book provided a stimulating look at the financial crises and a psychologically based and highly rigorous theory to support it. Providing a lens with which to consider the behaviour of individuals and in aggregate the overall economic outlook, as well as opening up a number of areas for future research and consideration.
November 14, 2018
As an amateur when it comes to economics, I found this interesting. The idea is to look at surveys and psychology to come up with a more realistic foundation for economics rather than rational idealizations. The authors advocate the idea that expectations are guided by past performance in a way that regularly over-projects past performance, either good or bad, leading to somewhat irrational expectations. They combine this with other psychological data to make a persuasive case that there can be a realistic micro-foundation for macro-economic phenomena. They apply this to the recent crises, but also a wider variety of phenomena.
The book had a small amount of mathematization which I had trouble following, but didn't seem crucial to my amateur understanding. What was more bothersome was how repetitive the book was of its main ideas. I don't know if this is more common in econ, or if the editor insisted the book be longer and so repetition was needed to reach a minimum length, but it was annoying.
My son works in bank stress-testing for the Fed, and the authors tied their work to that on pp. 198-99, which I liked.
The book had a small amount of mathematization which I had trouble following, but didn't seem crucial to my amateur understanding. What was more bothersome was how repetitive the book was of its main ideas. I don't know if this is more common in econ, or if the editor insisted the book be longer and so repetition was needed to reach a minimum length, but it was annoying.
My son works in bank stress-testing for the Fed, and the authors tied their work to that on pp. 198-99, which I liked.
August 23, 2026
According to the authors, this is "stylized" mathematical modeling. The problem with that is GIGO. If the initial assumptions are bad then the model is bad. The authors start early on by rejecting the premise of The Big Short: Inside the Doomsday Machine, i.e. that there was widespread factual knowledge lying around that people in the business could have just looked at to see that the whole mortgage financing thing was a crazy bubble.
The reasoning for their rejection is that people like Michael Burry were just shorting everything all the time and happened to get lucky with the timing of the 2008 collapse. That's plausible theoretically, but it's also testable in reality. It does not seem to be true according to the Big Short (and other books about the crash). So, is Michael Lewis lying? The authors don't provide any evidence to back up their extraordinary claims about the shortsellers before just trashing that pile of facts.
This seems fishy to me.
The reasoning for their rejection is that people like Michael Burry were just shorting everything all the time and happened to get lucky with the timing of the 2008 collapse. That's plausible theoretically, but it's also testable in reality. It does not seem to be true according to the Big Short (and other books about the crash). So, is Michael Lewis lying? The authors don't provide any evidence to back up their extraordinary claims about the shortsellers before just trashing that pile of facts.
This seems fishy to me.
October 10, 2022
Gennaioli and Shleifer show how behavior, and specifically diagnostic expectations - i.e the overreaction to both positive and negative news (by investors/lenders in this case), create credit cycles. At times the proofs could get a little hard to follow, but the insights of this book were clear - over-extrapolation based on recent data can cause exaggerations on the upside and downside. They blend this behavioral insight with a general theory of credit cycles. As it applies to investing or markets, my takeaways are that monitoring the levels of “junk” vs. safe or good credit (which can also be seen by narrowing/widening credit spreads) are a good indication of investment cycles.
January 31, 2019
ودون الدخول في تفاصيل أكثر، فإنّ هذا الكتاب الجميل من الكتب التي يجب على المهتمين بالاقتصاد قراءتها
a must read،
والجديد الذي أضافه من وجهة نظري هو أنّ الأزمات المالية يمكن التنبؤ بحدوثها، وقد حدث هذا مع الأزمة المالية العالمية
2008،
وليست غير قابلة للتنبؤ (بجعة سوداء) كما ذكر نيقولاس طالب.. لكن ما منع الناس من توقّع حدوثها هو اعتقاداتهم التي ترتّب عليها نتائج خطيرة بسبب الانزلاق في مغالطات إدراكية كشف عنها الاقتصاد السلوكي وعلم النفس.
a must read،
والجديد الذي أضافه من وجهة نظري هو أنّ الأزمات المالية يمكن التنبؤ بحدوثها، وقد حدث هذا مع الأزمة المالية العالمية
2008،
وليست غير قابلة للتنبؤ (بجعة سوداء) كما ذكر نيقولاس طالب.. لكن ما منع الناس من توقّع حدوثها هو اعتقاداتهم التي ترتّب عليها نتائج خطيرة بسبب الانزلاق في مغالطات إدراكية كشف عنها الاقتصاد السلوكي وعلم النفس.
October 30, 2018
To finally understand why traditional economics need to be revised
For anyone interested in understanding why no one could predict the GFC
This book will open new roads to be explored
For anyone interested in understanding why no one could predict the GFC
This book will open new roads to be explored
July 13, 2019
The authors have some pretty good ideas about modeling non-rational belief formation using insights from psychology, but I'm not sure this needed to be a book rather than a paper. The best part of this book for me was that it pointed me to the paper "Capital Market Blind Spots."
Did Not Finish
February 12, 2020This book is highly academic and not for a casual reader interested in economics. I could get through the first two chapters, but in chapter 3 we get into some deeper explanations involving some formulas I just couldn't parse. I chose to put it down at that point.
December 19, 2018
Reads more like a long chapter of a Handbook in Financial Economics than a book you read leisurely
July 7, 2019
This is a major step in modeling mistaken belief and exceptional errors lead to market corrections.
Displaying 1 - 13 of 13 reviews