How Our Beliefs Led to the Great Recession

Ten years ago, when Lehman Brothers collapsed on 14 September, 2008, the ensuing mayhem took almost everybody by surprise. With their A Crisis of Belief (Princeton University Press), Nicola Gennaioli, Professor of Finance at Bocconi, and Andrei Shleifer, Professor of Economics at Harvard, reinterpret the meltdown of the American financial system as a consequence of the erroneous beliefs of homebuyers, investors, and regulators. Beyond this episode, the book shows that survey data on the beliefs of investors and analysts challenges the conventional assumption of rational expectations. The book accounts for this evidence by integrating psychology into the analysis of boom-bust cycles, yielding insights that can help shape economic policy. They show that over-reaction to news is a key force behind many forms of financial instability, by causing both extrapolation of past trends and underestimation of tail risks. With the permission of Princeton University Press and the authors, Bocconi Knowledge publishes an excerpt of the book


The collapse of the investment bank Lehman Brothers on Sunday, September 14, 2008, caught almost everyone by surprise. It surprised investors, who dumped stocks and brought the market index down by 500 points on Monday. It surprised policymakers, who rushed to rescue other financial institutions after declaring for months that there would be no government bailouts. It also surprised economic forecasters. Only six weeks before the Lehman bankruptcy, in early August 2008, both the Federal Reserve and professional forecasters predicted continued growth of the U.S. economy. Contrary to that prediction, the U.S. financial system nearly melted down after the Lehman bankruptcy, and the economy slid into a deep recession. This happened despite extraordinary- and ultimately successful- government efforts to save the financial system after Lehman.

Why was the Lehman crisis such a surprise? After all, fragility has been building up in the financial system for quite some time. In the mid-2000s, the U.S. economy went through a massive housing bubble. As home prices rose, households levered up to buy homes with mortgages. Banks and other financial institutions levered up to hold mortgages and mortgage- backed securities. As the bubble deflated after 2006, the financial system experienced considerable stress, as reflected in runs on financial institutions, followed by bankruptcies, rescues, and mergers. Yet the system and the economy stayed afloat until the fall of 2008, supported by successful interventions by the Federal Reserve aimed to avoid a financial panic. By mid-2008, investors and regulators expected that, despite the deflating housing bubble, the situation was under control. On May 7, 2008, Treasury Secretary Henry Paulson felt that "the worst is likely to be behind us." On June 9, 2008, Fed Chairman Ben Bernanke stated that "the danger that the economy has fallen into a 'substantial downturn' appears to have waned."

The relative quiet before the storm, expressed in both the official and private- sector forecasts of the economy and the speeches of government officials, gives us important clues as to why Lehman was such a surprise. It surely was not the news of Lehman's financial weakness per se, since the investment bank was in trouble and expected to be sold for several months prior to its September bankruptcy. U.S. banks more generally were making large losses for several months as the housing and mortgage markets deteriorated, and no major economic news surfaced that weekend. Nor can the surprise be attributed to the government reiteration of its "no bailout" policy. For if that were the reason for the collapse, the markets would have bounced back as soon as it became clear on Monday that bailouts were back in. In fact, markets bounced around a bit but continued their slide as the financial system deteriorated over the next several weeks, despite all the bailouts.

The evidence on the beliefs of investors and policymakers instead tells us that the news in the Lehman demise was the extreme fragility of the financial system compared to what was previously thought. Despite consistently bad news over the course of 2008, investors and policymakers came to believe that they had dodged the bullet of a major crisis. The pressures building up from home price declines and mortgage defaults were attenuated by the belief that the banks' exposure was limited and alleviated by effective liquidity support from the Fed. The risks of a major crisis were neglected. The Lehman bankruptcy and the fire sales it ignited showed investors and policymakers that the financial system was more vulnerable, fragile, and interconnected than they previously thought. Their lack of appreciation of extreme downside risks was mistaken. The Lehman bankruptcy had such a huge impact because it triggered a major correction of expectations.

Ten years after Lehman, economists agree that the underestimation of risks building up in the financial system was an important cause of the financial crisis. In October 2017, the University of Chicago surveyed a panel of leading economists in the United States and Europe on the importance of various factors contributing to the 2008 Global financial Crisis. The number- one contributing factor among the panelists was the "flawed financial sector" in terms of regulation and supervision. But the number-two factor among the twelve considered, ranking just below the first in estimated importance, was "underestimation of risks" from financial engineering. The experts seem to agree that the fragility of a highly leveraged financial system exposed to major housing risk was not fully appreciated in the period leading to the crisis.

These judgments are made with the benefit of hindsight. The world, however, has witnessed an extensive history of financial bubbles, expanding credit, and subsequent crises as the bubbles deflated. Errors in beliefs appear in multiple narratives. [...]. Since the 2008 crisis, a great deal of new systematic evidence on credit cycles, both for the United States and worldwide, has been developed [...]. Much of this work points to errors in expectations over the course of the cycle, which stands in marked contrast with the conventional view in macroeconomic and finance that expectations are rational. Here we take this point of view further and put inaccurate beliefs at the center of the analysis of financial fragility.

To this end, we seek in this book to accomplish three goals. First, we would like to show that survey expectations data are a valid and extremely useful source of information for economic research. Expectations in financial markets tend to be extrapolative rather than rational, and this basic feature needs to be integrated into economic analysis.

Second, we seek to provide an empirically motivated and psychologically grounded formal model of expectation formation that can be used across a variety of domains, from lab experiments to studies of social beliefs to dynamic analyses of financial and macroeconomic volatility. In economics, nonrational beliefs have been typically formalized using so- called adaptive expectations, which describe mechanical extrapolation of past trends into the future. This approach has been criticized on the grounds that individuals are forward- looking in that they react to information about the future, not only to past trends. We develop a more realistic non-mechanical theory of belief formation, building on evidence from psychology. In this theory, decision makers react to objectively useful information, but in a distorted way.

Third, we use this model of expectation formation to account for the central features- including both market outcomes and beliefs-of the 2008 crisis both before and after Lehman and to explain credit cycles and financial fragility more generally. With the model of expectations we propose, many empirically established features of financial markets emerge in otherwise standard dynamic economic models. Getting the psychology right allows us to shed light on the conditions under which financial markets are vulnerable to booms and busts. It may also help in thinking about the role of economic policy.