Listening to all the fully justified outrage about bonuses getting paid to the employees of AIG who took all the risky bets reminds me of the recriminations and second-guessing after the two space shuttle disasters.
Undoubtedly, if Edward Tufte put his mind to it, he could come up with a fascinating graphic about the data leading up to the collapse of AIG, as he did with the launch decision for the ill-fated space shuttle Challenger. But in the meantime, here are some thoughts based on the extremely thorough and interesting 566-page book, "The Challenger Launch Decision," which I read years ago.
Normalization of deviance leads to incrementally increased comfort with greater and greater risk.
The shuttle organization became more comfortable with doing things that lay outside the limits of specifications, or at least edged closer to the limits of specs. Each time, this would reset their tolerance for deviation from normal.
Ultimately, this led to decisions that pushed risk over the edge. Like AIG (and much of the decision making that led up to the economic collapse), in hindsight, these decisions seem outrageous, but within the bubble, they seem reasonable and with precedent. This is not to excuse them, by any means, just to note that we need to be especially on-guard and reward those who are the lone voices questioning the decisions when the stakes are so high.
The assumption that others know the parameters and risks is wrong.
In the case of the shuttle, NASA engineers believed that engineers at Thiokol, the maker of the external rockets, knew the limits when, in fact, there was a disconnect between the specifications that NASA used for launch decisions and the specifications to which the rockets were designed.
Obviously, plenty of people at AIG, and the banks that did much of the investing with them, were quite familiar with the risks, but many others were not. Thanks to how the credit-rating agencies evaluated Credit Default Swaps, risks seemed lower than they were, hiding the true, extreme risks from those less familiar with the ins and outs of credit default swaps.
Decisions are heavily influenced by emotions.
Managers are not "amoral calculators," to use Vaughn's phrase. Too much in the world of economics also assumes that people act rationally--consumers, bankers, and investors make this assumption alike, despite the daily evidence to the contrary (namely the emotion-driven swings of the stock market).
People will do things that are most definitely not in their self-interest (or in the interests of others for whom they are supposedly responsible), if they get caught up in the emotion enough.