Eric Schoenberg says that when a recent post of mine asked "Was Risk Misperceived, Misrepresented, or Misallocated?", it missed another possibility. Via email:
I have been a silent follower of your blog for some time but wanted to respond to you directly with regards to a couple of your recent postings, specifically your Dec 28th post on "Was Risk Misperceived, Misrepresented, or Misallocated?" and your Oct. 10th post on "Does Income Concentration Cause Bubbles?".
By way of background, I was a partner in a tech-focused investment bank in the 1990s and became fascinated by the behavior I observed during the internet bubble, particularly that of my partners, who ignored my warnings in late 1999 that the end was near. I was proven right, of course -- the firm was sold in distress in 2003 for about 3% of what we might have gotten in early 2000 -- and I became so obsessed with the question of explaining the behavior of my partners, who were intelligent and financially sophisticated but couldn't see what to me was an incredibly obvious risk, that I returned to academia, got a PhD in psychology, and now teach a class in behavioral economics at Columbia Business School while conducting research on bubbles.
Why did my partners want to hold onto such a risky asset? Prospect theory says that people become risk-seeking when they find themselves in a situation of potential loss, yet a bubble would appear to be an environment where everybody is making money. My theoretical insight was that if my partners' frame of reference was set by social comparisons with friends and colleagues who had "made" hundreds of millions of $, then the fear of lagging behind could lead to a desire to take on greater risk. And, sure enough, when I run experimental asset markets (I will assume you are at least somewhat familiar with this literature based on the design of Smith, Suchanek, and Williams) where I give social comparison information (i.e. I tell players either how much the person with the most in a market has, or how much the person with the least in a market has), bubbles are significantly larger when everyone gets "upward" comparison info.
So I was amused, but not surprised, that you asked "Was Risk Misperceived, Misrepresented, or Misallocated?", but did not include "embraced" as another possibility. Given economists' general predilection for revealed preference, I would have thought this would be an idea more generally discussed, but its pretty much non-existent. There is, however, a recent paper by DeMarzo, Kaniel and Kremer showing that when rational agents care about "scarce" goods whose price is determined by the wealthiest members of a cohort, then they will participate in a bubble even when they know it will collapse. Of particular note, they have a great line where they say (my close paraphrase) that "to an outside observer who is not aware of the underlying objective function, it might appear that some agents become risk-loving." So when you say "We know that excessive risk taking was a factor in the financial crisis, but why people were willing to take on excessive risk?", you are ignoring a point emphasized by Keynes, and many others, but actively disdained by free-market fundamentalists: there is no a priori reason to believe in general that behavior that is individually rational is collectively rational. What, after all, is "excess" risk?
Thus, the answer to your other question is that income concentration both causes and is caused by bubbles. It causes bubbles to the extent that it makes more salient how far ahead the economic winners are, and, empirically, certainly in my studies and, though I haven't seen any papers to this effect, quite clearly in the real world, bubbles generate greater inequality as well.