In the unfolding of the present financial crisis, one of the most commonly asked questions is:  With all the Nobel Prize winners watching the markets and complex computer models floating around, how was it that the best and the brightest didn’t see disaster coming? 

Moreover, there were plenty of voices sounding the alarm, and all of them were ignored.  The Financial Times,¹ for example, wrote in late 2007, before the market crashed, that risk was clearly not being well managed on Wall Street.  Michael Lewis, the best-selling author of numerous books, including Liar’s Poker² and Moneyball,³ had been warning us since the crash of 1987.  More recently, Nassim Nicholas Taleb warned us in 2005 with his book Fooled by Randomness⁴ and again in 2007 with the best-selling book The Black Swan.⁵  So why did most people miss the signs?

The answer is complex.  In part, it has to do with the science of decision-making discussed in the previous trend:  People don’t necessarily act rationally.  They act emotionally much of the time.  And when the immediate rewards are large, there is a powerful incentive to keep on with business as usual, even if that business is founded on faulty concepts. 

In fact, Richard A. Posner, a judge on the U.S. Court of Appeals for the Seventh Circuit, recently published a book called A Failure of Capitalism⁶ in which he argues that the risks that banks took in such instruments as mortgage default swaps were rational risks precisely because of the exorbitant rewards involved.  He makes a distinction, however, between individual rationality and collective rationality. 

On an individual level, says Posner, bankers make so much money that they don’t have to worry about the risk.  If there was a large reward attached to the risk, they could proceed.  Moreover, if they lost their jobs, their severance packages protected them.  So in effect, they were like pilots flying a plane in which only the pilots get to wear parachutes.  If the plane goes down, only the passengers...