Are You a Behavioralist or an Institutionalist?

Noah Smith’s response to my previous post on the future of behavioral economics makes an interesting point: behavioral economics is indeed somewhat more established in finance.  I think this is correct and the examples Noah cites are all worthy representatives of the sub-field of behavioral finance.

Is behavioral finance gaining ground in the wake of the financial crisis?  My own reaction to financial crisis is that macroeconomists indeed have a lot of work to do.  I don’t think simple modifications to existing DSGE models are going to do the trick.  Instead, I think that we need to improve our understanding of the architecture of financial markets by gathering data on financial flows and contracts of the key participants in these markets and hopefully getting a better sense of how these markets connect with the “real” economy.  We can then incorporate this institutional detail into quantitative DSGE models so we can be better prepared for the next crash.

An alternative reaction is to say that what matters most is the psychology of the market participants.  Perhaps asset price bubbles and speculative behavior is fundamentally tied to “sentiment” or other factors that have traditionally been in the domain of psychology.

Of course we don’t have to make a choice here.  It’s not as though learning more about the role of psychological or subjective forces in markets is a bad thing.  Even if I think that we would be best served by focusing on financial market institutions, we would certainly be made better off with a greater understanding of the behavioral tendencies of financial market participants.

Nevertheless, I think it’s telling to think introspectively about where more work is needed.  Do you think “originate to distribute” behavior is best understood as rational people reacting to poorly designed market institutions (or poor policies) or do you think that this behavior is caused by irrational over-optimism?  Do you think that when the loan markets “froze” (a terribly imprecise term incidentally) that this was a rational decision on the part of lenders who were justifiably concerned that they either wouldn’t get paid back or that they needed to retain their liquid assets rather than commit them to the markets or do you think that frozen loan markets were caused by irrational panicking?  How you answer these questions might tell you a bit about whether the future of behavioral finance is bright or dim.