In the aftermath of the Madoff Ponzi scheme, psychologist Stephen Greenspan writes in The Wall Street Journal on why we continuously fall for financial scams—and in the process describes the ‘anatomy’ of gullibility.

Gullibility is a sub-type of foolish action, which might be termed “induced-social.” It is induced because it always occurs in the presence of pressure or deception by one or more other people. Social foolishness can also take a non-induced form, as when someone tells a very inappropriate joke that causes a job interview or sales meeting to end unsuccessfully. Foolishness can also take a “practical” (physical) form, as when someone lights up a cigarette in a closed car with a gas can in the back seat and ends up incinerating himself. As noted, the same four factors can be used to explain all foolish acts, but in the remainder of this paper I shall use them to explain Ponzi schemes, particularly the Madoff debacle.

Greenspan’s four factors of gullibility are situation, cognition, personality and emotion.

Toward the beginning of this article Greenspan mentions the book Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, a book that Jonah Lehrer—editor at large of Seed Magazine—classes as one of the top five books on irrational decision-making. The book was first published in 1841 and is in the public domain (available from: The Gutenberg Project, The Library of Economics and Liberty).

The economic theory of moral hazard is “the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk” (e.g. holders of car insurance may engage in riskier behaviour than non-holders, investors may take unnecessary risks if they expect to be bailed out in case of huge losses, etc.).

James Surowiecki—author of The Wisdom of Crowds—questions the validity of the theory, claiming that we may be overestimating the effect of moral hazard… if it exists at all.

The biggest reason that moral hazard matters less than it might is that it can operate only if people actively countenance the possibility that their decisions could lead to complete disaster. But it’s well documented that people generally, and investors particularly, are overconfident and significantly underestimate the chances of being wiped out. The moral-hazard fundamentalists argue that banks and other financial institutions will act recklessly if they think they’ll be rescued in the event of failure. But Wall Street was reckless because it never believed that failure was even a possibility.