We've heard and read a lot recently about Wall Street's intoxication with high-risk subprime mortgages. So why do these mortgage-backed securities breed such bad economic behavior? I recently asked behavioral economist Dan Ariely, author of Predictably Irrational: The Hidden Forces That Shape Our Decisions.

Mac Greer: Dan, in your book, you talk about how when we deal directly in cash, we tend to be more honest, and so I want to ask you about that in light of this current crisis. We are hearing a lot about these mortgage-backed securities and credit default swaps and all sorts of other exotic, hard-to-understand investments. Does dealing with these more complex non-cash financial-type instruments make us more willing to take on risk? Does it make us less honest?

Dan Ariely: Yes, I absolutely think so. Here is the deal. So you ask people, would you take $0.10 from a petty cash box in the office, even if nobody will ever find you out? People will look at you as if you are crazy. If you ask people, would you take a pencil, many people say yes. The question is, why is a pencil OK and $0.10 [is] not?

It turns out that with a pencil, we can tell ourselves stories about it. So we can say, "Oh yes, the workplace really wants me to take a pencil, because then I could work more at home, or I could give it to my kid and they could leave me alone. I could check my BlackBerry." We can tell stories about it, and all these stories make it possible for us to cheat in those regards.

In our experiments, we basically had a setup in which we gave people a sheet of paper with 20 simple math problems they could solve with no problem, but we didn't give them enough time. So when the five minutes were over, we said, "Hand me the sheet of paper." We checked how many questions they got correct and we paid them a dollar per question. And they solved four questions, four dollars.

Another group we said, when the five minutes were over ... "Please shred the piece of paper and tell me how many questions you solved." So now they had the chance to cheat, and a lot of people cheated. The average went from four to seven, and it wasn't as if we had a few people who cheated a lot; instead, we had a lot of people cheat just a little bit.

The most relevant condition for our discussion here is one in which we told people at the end of five minutes to shred the piece of paper and now come and ask us for money -- but don't ask for money, ask for tokens. So they said, "Mr. Experimenter, I solved X problems; give me X tokens." We gave them a token per question. They walked 12 feet to the side and exchanged the tokens for dollars. In this condition, people doubled their cheating. The ideas is that being one step removed from money, for just a few seconds, kind of ... liberates us from our moral shackles.

Now think about what it means about an executive who is backdating the stock options. Or think about what it is when you have all the securities that nobody really knows how to price. What happens when the incentive of the banker is to see it in a certain way? All of these added degrees of flexibility would help them see it in a way that is comfortable for them, and not necessarily reflecting reality. I think that is a lot of what is happening.

All of these complex products ... are so complex that very few people I have known, anybody, understands them truly. As a consequence, the latitudes that we allow ourselves to take are just incredible.

Greer: And Dan, is that ultimately more of an issue of people not being honest, or is it more of an issue of people taking on more risk because they are dealing in these illiquid investments?

Ariely: I think it does both. It basically says that the more flexibility you have, the easier it is for us to justify whatever it is we want to justify. So it could be that it is for personal gain. It could be for glory. It could be that I am behind today on my investments, or I am behind today on my ... desire of what I need to get, or maybe I am behind because I am losing actually money -- and now I can change my risk strategy. Nobody wants you to change your risk strategy if you are behind for the day, but if I have these tools, and I don't want to really feel that I am losing, and everything is flexible and more easily justifiable, people might take much, much more risk.

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