Cognition, Market Sentiment and Financial Instability: Psychology in a Minsky Framework

Introduction 'We can model the euphoria and the fear stage of the business cycle. Their parameters are quite different. We have never successfully modelled the transition from euphoria to fear.' Quantitative models have been a central part of the story of the present financial crisis. It was the models used in financial markets which provided the basis for an assessment of risk exposure which went so badly wrong (see eg Haldane 2009). But economists' models too failed to capture the systemic risk which resulted from market behaviour (see eg Colander et al. 2009). Alan Greenspan's remark, quoted above, is thus interesting in two respects. First, he identifies the problem as a failure to model the turnaround at the peak of the cycle. Second he depicts the cycle in psychological terms, such that the turnaround is one from greed to fear. The task for economists would appear to be to incorporate psychology more successfully in economic models so that financial instability can in future be predicted and understood better. 2 The focus of this paper is therefore on how, and in what way, psychology can contribute to our understanding of financial instability, as input to modelling by the monetary authorities or otherwise. It will be argued that there is a correspondence between the view taken of modelling on the one hand and the way in which psychology can be incorporated on the other. The argument has been made (Dow 2004) that formal modelling (and particularly the search for the single best model) cannot be the full answer to understanding the economy, far less prediction. Any one model can only provide partial knowledge, to be supplemented by other forms of knowledge, including judgement (an argument expressed most recently in relation to the present crisis by Lawson, 2009). Indeed Downward and Mearman (2008) have argued that this process can usefully be understood as the application of the method of triangulation. In contrast, the behavioural finance literature aims to adapt rational choice models using inputs from psychology. Was the failure of most economists to anticipate the crisis due, as Alan Greenspan suggests, to insufficient development in the capacity to model changes in sentiment? In exploring the use of psychology in behavioural finance, the focus will be on the distinction drawn between cognition and emotion (sometimes expressed as the distinction between rationality and irrationality). This distinction itself is then probed in order to discuss the …