Inside Job, Inside Minds: A Behavioral Look at the 2008 Financial Crisis

The global economic crisis of 2008 cost tens of millions of people their savings, their jobs, and their homes. This crisis was no accident but was caused by an out-of-control, unregulated industry and the failure of financial institutions to manage the financial system. The Oscar-winning documentary “Inside Job” explored the underlying causes behind the crisis, bringing to light the complex amalgamation of reckless risk-taking, greed, and regulatory failures that precipitated the devastating global economic meltdown. 

What's remarkable is that this crisis had effects all across the world; it wasn't limited to the United States. The documentary's observations by Charles Keating emphasize how these risky investments caused a number of loan organizations to fail, causing severe financial losses for multiple individuals. The documentary also discusses the effects of deregulation, which exposed numerous significant financial institutions for engaging in illegal activities like money laundering and client fraud. The widespread issuing of loans to those who were clearly incapable of repayment serves as additional evidence of the bankers' self-serving motivations and severe mismanagement.Inside Jobs illustrates the sobering reality that a small group of influential individuals can wield enormous power over the global financial system.

Economic theories were not enough to explain the intricate relationship between human behaviour and the systematic factors which led to the crisis of 2008. Traditional economic theories help understand market behaviour and rational decision-making, but they frequently ignore the complex psychological and behavioural components of economic events.  In the case of the 2008 crisis, it became evident that human behaviour, driven by a range of psychological factors, played a pivotal role in shaping the crisis. 

From a psychological perspective, the film provides valuable insights into the behaviour of the individuals responsible for these actions. Two psychological theories, moral hazard and prospect theory, can help us understand the decision-making processes at play.

Moral hazard is a psychological concept that explains how individuals or institutions might take on greater risks when they believe they won't bear the full consequences of their actions. In the context of the 2008 financial crisis, bankers and financial institutions displayed moral hazard. In the years building up to the crisis, banks became acutely aware that their size affords them a certain level of security. When they reach a certain magnitude, they effectively become too big to fail. This perception of being "too big to fail" only worsened the moral hazard dilemma. Banks knew that because of their enormous influence on the financial system, the government was likely to step in to save them from a catastrophic systemic collapse, which is exactly what happened during the 2008 financial crisis. This feeling of security prompted financial institutions and bankers to prioritize massive bonuses and short-term profits above the long-term sustainability of their organizations. 

Psychologically, moral hazard can be attributed to a phenomenon known as the "principal-agent problem." This problem arises when individuals (agents) make decisions on behalf of others (principals) but do not fully bear the consequences of their actions. In the case of the financial crisis, bankers, acting as agents for their institutions, pursued risky strategies to maximize their own gains, even when it posed significant risks to their organizations and the broader economy.

Secondly, prospect theory, a cornerstone of behavioural economics, offers insights into how individuals make decisions under conditions of uncertainty. It posits that individuals do not always make rational choices when faced with potential gains and losses; instead, their decisions are influenced by psychological biases.

The movie reveals how the possibility of short-term benefits, such as huge bonuses, has a significant impact on bankers' decisions. This is consistent with prospect theory, which holds that when presented with opportunities for profits, people are more likely to take risks. Even if the long-term effects were uncertain, bankers were drawn to high-risk activities by the promise of substantial profits.  The Chief Economist of the International Monetary Fund, Dr. Raghuram Rajan, goes on to explain this phenomenon by emphasizing how the expansion of financial development has increased global threats.  He emphasizes that the widespread use of huge cash bonuses linked to short-term earnings, sometimes known as "incentives," drove bankers to make risky decisions that posed serious threats to not only their own institutions but also, potentially, the stability of the entire global financial system.

Additionally, prospect theory suggests that individuals are loss-averse, meaning they fear losses more than they value equivalent gains. This fear of loss can explain the panic and reckless behaviour observed during the crisis. When faced with the potential collapse of their institutions, bankers and investors may have been more motivated by a desire to avoid losses than to pursue rational, long-term strategies.

In conclusion, the film "Inside Job" provides a stark portrayal of how moral hazard and prospect theory influenced the decisions and actions of individuals within the financial sector, ultimately leading to the 2008 financial crisis. Understanding these psychological factors is crucial for designing effective regulatory and risk management strategies to prevent such crises in the future. It underscores the importance of aligning economic policies with a deep understanding of human behaviour and its biases.