The best books on the impact of psychology on economics and finance

To my mind, this book is tops in providing a general exposition of the two-system psychological approach to analyzing human judgments and decisions. For over half a century the book’s author, psychologist Daniel Kahneman, has been has been a major contributor to the modern psychological approach that underlies behavioral economics. In 2002, Kahneman was awarded the Nobel Prize in economics for his contributions. I feel fortunate to have known him since the 1970s and to have learned so much from him and his late co-author Amos Tversky.

Nudge is a seminal work about using psychological insights to help people make better economic decisions for themselves. The principles which authors Richard Thaler and Cass Sunstein articulate in the book are being applied globally in what have come to be called “behavioral insight teams” or “nudge units.” I would call this book a “game changer,” because prior to its publication there was a general view that people are too set in their psychological ways to change their behavior, even when doing so would be to their benefit. The germ of the main ideas in Nudge trace back to work which Nobel laureate Thaler did earlier in his career. Much of this work was with coauthors, of which I was one, which makes me especially appreciative of how remarkable the book is.

The term “irrational exuberance” which forms the title of this book, entered the public lexicon in 1996, days after the book’s author, Nobel laureate Robert Shiller, gave a presentation about stock market bubbles to the Federal Reserve. Alan Greenspan, who was Fed chair at the time, used the term in a public speech; and the rest is history. The book Irrational Exuberance provides an account of how psychological forces generate asset pricing bubbles. The book was published during the dotcom bubble, and proved to be prophetic in the way it anticipated the subsequent housing pricing bubble which preceded the global financial crisis and associated great recession. Readers will find amazing insights in this book, especially about the way that history repeats itself when it comes to asset pricing bubbles.

Keynes’ book is not just a classic, but to my mind is the finest book in economics written in the first half of the twentieth century. Although I studied the book as an undergraduate student, at the time I failed to appreciate what Keynes wrote about the role psychology played in economic decision making. It was only after becoming a behavioral economist myself, and re-reading the book, did I realize that Keynes was a stellar behavioral economist. Although many professionals learn about Keynes’s ideas from other sources, there is nothing like the original. In this work Keynes speaks to us about how human psychology impacts economic decisions and events. Those who read carefully will see that he writes about psychology, optimism, confidence, and sentiment – terms very much in vogue today among modern behavioral economists.

Hyman Minsky might well have been the most underrated economist during the second half of the twentieth century. In Stabilizing an Unstable Economy, Minsky identified the psychological factors that create in financial markets and exacerbate economic downturns. Viewed against the backdrop of recent financial crises, his writings appear prescient. Readers of this book will discover that Minsky explained that the same factors which underlie economic instability also underlie the creative spark that produces economic progress. Readers will also learn that Minsky warned about being naïve in thinking that we can avoid instability.