Could today's financial crisis be the product of psychological irrationality?  Economic theoreticians always assume that citizens are rational people who seek to maximise their welfare and that enterprises seek rationally to maximise profits.  If behaviour were really so rational, we would never need psychologists -- who know in reality that much human behaviour is motivated by the irrational.

As Warren Buffet said: "It's only when the tide goes out that you learn who's been swimming naked".  Thus, the current global financial crisis is leaving orthodox economists undressed as it challenges their notions of economically rational behaviour. 

"Behavioural economics" has always been a marginal sideline in economics despite the awarding of the Nobel Prize in economics to psychologists Amos Tversky and Daniel Kahneman.  Their Prospect Theory, which showed how people become risk averse while gaining and risk seekers while losing, has led to many related ideas and answered many puzzles in economics and finance. 

Behavioural economics is now having a field day.  Perhaps a big mistake has been leaving the economy to the economists.  Even Alan Greenspan seems to be now converted -- "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms". 

So, what is behavioural economics?  It seeks to study how humans really behave in markets, rather than assuming they behave like automatons.  It combines economics, psychology and sociology.  While behavioural economics has many implications for policymakers, cultural and social values differ across countries implying varied responses to similar incentives.  Americans seem to have a higher risk appetite than others. 

What are the insights that behavioural economics can give us regarding the financial crisis?  First is overconfidence.  Surveys show that consumers are often over confident regarding their financial management skills.  This could explain why investors can ignore warning signs of financial bubbles.  Then there is the phenomenon of sending good money after bad.  Rational decision makers would only hang on to investments based on their assessment of future costs and benefits, and not try to chase sunk costs.  But many investors are like gamblers who are trying to recover past losses.

Nassim Nicholas Taleb, writer of "The Black Swan", has identified a number of perpectual biases that distort our tihinking: our tendency to see data that confirm our prejudices more vividly than data than contradict them; our tendency to overvalue recent events when anticipating future possibilities; our tendency to spin concurring facts into a single causal narrative; and our tendency to applaud our own supposed skill in circumstances when we've actually benefited from dumb luck. 

When looking at today's financial crisis, we can see many errors of perception, as traders did not see the possibility of rare events, got caught in social contagions, reinforced each other's risk assessments.  Moreover, they falied to see how tightly linked global netoworks could transform small events into big disasters.     

So when we are wondering why investment banks excessively leveraged their debt, why homeowners borrowed beyond their means, why bankers sold loans to ninjas (no income, no job or asset), or why governments stuck with weak regulations, behavioural economics and the world of the irrational may have more answers than orthodox economics.