On April 6, 1994, an aircraft carrying the Rwandan President, Juvénal Habyarimana, a member of the Hutu ethnic group, was shot down as it prepared to land in Kigali. Almost immediately a genocide began that, in only 100 days, was to leave about one million people dead.

Sharpening their machetes on the pavements, Hutus hacked their Tutsi neighbours to death. They encountered the little children with whom their own sons and daughters had been playing only days earlier and ran them through with swords. They raped half a million Tutsi women.

All the time the public radio spurred them on. “Crush the cockroaches,” the Hutus were urged. And so they did, killing and raping until they were forced to stop at the point of a gun by a Tutsi rebel army. I want you to keep this story in mind while I talk to you about bankers and their bonuses.

It was impossible to listen yesterday to the bankers arrayed before the Treasury Select Committee without concluding that my colleague Anatole Kaletsky has a point. He believes that economics is broken. And as the MPs put their questions to the money men, the evidence was with Anatole. Economists could indeed do with some help in understanding the behaviour that yesterday's session discussed - the outlandish pay these people awarded themselves, the risks that they took, the way they were able fluently to explain away extraordinary failure.

Let's just take pay as an example. Surely, as conventional economics teaches, the wages of bankers are just another price? These bankers were being paid only what was necessary to ensure that the supply of bankers met demand, weren't they? If they were being paid more than necessary, wouldn't they simply be undercut by new entrants? Yet anyone with common sense can see that this conventional economic account doesn't seem a remotely realistic description of how bankers' pay was really determined. Well, certainly not a remotely complete description.

Here are three ways in which social psychology and behavioural economics might help conventional economists to complete the description of the bankers' behaviour.

The first is this - human beings copy each other. Or to use a more technical term, they adhere to social norms. The classic experiment that demonstrates this was conducted by Professor Solomon Asch in the 1950s. Participants were shown a card with a line on it. Then they were given three more cards with lines of varying length and asked which of them matched the original. The answer was easy, but many got it wrong. Why? Because before they got to choose, Asch's confederates, posing as participants, had chosen one of the wrong cards as their “guess”. Social pressure made the real participants conform.

The pressure to conform is very strong indeed. As the old tale of the Emperor's New Clothes relates, most of us are unwilling to dissent. And this social pressure is particularly strong in small professional groups, talking to each other. Isn't this an important part of understanding bankers' pay? And comprehending why so many invested in products that they didn't understand?

The second useful insight of social psychology is that humans like to be consistent. We tell ourselves stories and are incredibly reluctant to abandon them. Indeed Tim Lott, in his magnificent memoir The Scent of Dried Roses, argues convincingly that being forced to abandon the story that you have told yourself, is such a threat to identity that it can lead a vulnerable person to suicide.

This behaviour, this determination to stick by a good story, was the cause of the disaster that befell the banking system. The evidence accumulated that we were seeing a financial bubble that would surely burst soon. Yet this evidence was ignored because it challenged the story that we were living through a period of great prosperity through our own inventiveness,. And so the bubble burst instead of being gently deflated.

Adherence to a consistent narrative also explains why all bankers think their pay is necessary. And then pay their colleagues the same to maintain the illusion. I think that in this way psychology has much to teach about why, even now, many bankers insist that their bust banks have to pay huge bonuses.

The third helpful insight comes from behavioural economics. Professor Dan Ariely calls it relativity. “Most people don't know what they want,” he writes in his book Predictably Irrational, “until they see it in context.” And he provides an example. When Williams-Sonoma first introduced a home bread-making machine for $275 they couldn't shift any. No one knew what it was, or whether it was really worth the money. So on the advice of a marketing company, Williams-Sonoma introduced a rival. This machine was larger and much more expensive. Sales of the orginal began to rise. Consumers now saw the product in context.

When setting wages, bankers don't start from scratch. They don't consider if they really need to pay that wage to recruit someone. They use the salaries of others as an easily available anchor point. And they don't notice as the whole lot of them float away from what is necessary.

Is all this an argument against free markets? No. I started with the story of the Rwandan genocide because it is a classic example of collective madness - of a warped social norm, and consistency to a terrible narrative. Social psychology explains human behaviour, and that behaviour isn't created by free markets. Governments and social groups can be much worse. And free markets at least provide the opportunity for someone to make a fortune by dissenting.

We need the little boy who noticed that the Emperor had no clothes. And the free market remains the best way to get him to speak up.

daniel.finkelstein@thetimes.co.uk

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