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The Science of Economic Bubbles and Their Expiration / Gary Stix

The most severe economic crisis since the "Great Depression" has led to a reexamination of what is happening in the financial markets and of the way decisions are made in financial matters

Volunteers distribute soup to the needy during the economic depression of the thirties in the USA. From WIKIMEDIA
Volunteers distribute soup to the needy during the economic depression of the thirties in the USA. From WIKIMEDIA

It's like a scene from a bad movie. A gun is pressed to a man's forehead, the screen goes dark, and then a loud explosion is heard. If a forensic investigator had traced the trajectory of the bullet, he would have found that the bullet passed through the prefrontal cortex, one of the brain's decision-making centers. It is no wonder that the few who survive after being hit in this area show great changes in personality. One of the most famous cases in the history of neurology happened to Phineas Gage, a railroad worker who lived in the 19th century. An iron rod penetrated his prefrontal cortex. He did not die from the injury, but the ability to make logical decisions was lost to him. Cocaine addicts sometimes do similar harm to themselves. The disturbance caused by the use of the drug may also cause those who have withdrawn to crave it every time the bass beats of techno music are heard, for example, as it reminds them of the times when they were affected by it.

Even people who don't use illegal drugs and who have never been shot in the head have to face the fact that some of the decisions being made in their frontal lobes can lead them astray. As a matter of fact, a certain site in the prefrontal cortex, known as the ventromedial (ventral-middle) prefrontal cortex and denoted by the initials VMPFC, is suspected of being one of the causes of the great economic collapse that rocked our world.

The VMPFC, it turned out, is one of the centers where an illusion is created that economists call "the money illusion". It manifests itself when people ignore obvious information about the misleading effects of inflation, and then, without logic, decide that a certain purchase is worth much more than its true value. The money illusion can convince potential buyers that a home is always a great investment due to the misconception that its price is always going up. Robert J. Shiller, professor of economics at Yale University, claims that the poor logic caused by the money illusion was one of the reasons for inflating the housing bubble: "Since a person usually remembers how much he paid for his house many years ago, but does not remember the price of many other things in those days, he mistakenly believes that house prices have risen more than other prices. This creates an excessive and incorrect assessment of the profit potential involved in investing in a home."

For decades economists have debated the question of whether the illusion of money in particular and the effect of irrationality on transactions in general are nothing but an illusion themselves. Milton Friedman, the renowned monetary theorist, was based on the assumption that consumers and employers are not mistaken by illusions, but always use logic and take inflation into account when they buy or pay salaries. That is, they correctly estimate the true value of the goods.

But today the ideas of behavioral economists, who study the role of psychology in making economic decisions, are receiving more and more attention. Scientists from all kinds of fields are trying to understand why the world economy crashed so fast and hard, and their suggestions are confirmed by neuroscientists who take pictures inside the skull of the VMPFC and other areas of the brain. One experiment reviewed in March 2009 in the Proceedings of the American National Academy of Sciences is worth noting. The experiment was done by researchers from the University of Bonn in Germany and from the California Institute of Technology (Caltech). They showed through brain scans that some of the decision-making circuits in the brain show signs of the money illusion. A portion of the VMPFC lit up when the subjects in the experiment were reminded of a higher amount of money than a previous amount, even though the relative purchasing power of that amount did not change because prices rose accordingly.

The illumination of a point behind the forehead that is responsible for a wrong perception regarding money is just one example of the perfection of a research direction that has already led to the discovery of centers in the brain associated with the primal motives of the investor: fear (amygdala) and greed (nucleus accumbens, which are attributed to him, and perhaps it is not surprising, also connection to sexual desire). A high-tech fusion of brain imaging, behavioral psychology, and economics has begun to provide clues as to how people, and entire economies made up essentially of a collection of those people, can go off the rails. Together, these fields of research try to find out why an economic system that incorporates nominal defense mechanisms against collapse can suddenly deteriorate into deflation. Part of this research is already being used to outline the Obama administration's course of action in its attempt to stabilize the banking system and the housing industry.

The illusion of rationality

The behavioral ideas, in which interest is now increasing, disbelieve in some of the principles of modern economic theory, including the assumption that all buyers and sellers belong to the species "homo economicus", which is a completely rational being whose actions are motivated by concern for his own affairs. "Whatever the conditions, the person in classical economics is an automaton capable of thinking objectively," writes financial historian Peter Bernstein.

Another main belief in the concept that the existence of rationality is a Messianic doctrine is the efficient market hypothesis, which holds that all previous and current information regarding a product is reflected in its price, and that the market reaches an equilibrium between buyers and sellers when the "correct" price is determined. This balance between supply and demand can only be undermined by an external shock, such as an unexpected change in the price set by an oil cartel. This is how the balance is maintained in the dynamics of the financial system. The classical theory declares that the internal dynamics of the market cannot lead to the creation of a feedback loop in which the rise of one price causes the rise of another price and a bubble inflates, and after a while the direction reverses and the economy becomes unstable and unhealthy.

According to the efficient market hypothesis, simply put, the risk involved in a bubble bursting will be expressed in the existing market prices: in the price of houses and risky mortgages (the sub-prime mortgages) and in packages of what today are called "toxic collaterals". But if this is true and markets really are that efficient, how could prices have plummeted so sharply? Even the former chairman of the US Federal Reserve, Alan Greenspan, expressed his astonishment at the failure of the accepted theory. Greenspan, one of the staunch advocates of the efficient market idea, told a congressional committee in October 2008 these words: "All those who fostered the self-interest of lending institutions to protect the capital of their shareholders, and I am at the head of them, are now shocked and suitably shocked."

animal soul

The behavioral economists who try to identify the psychological factors that lead to the inflation of bubbles and serious violations of the equilibrium in the markets are the successors of the psychologists Amos Tversky and Daniel Kahneman, who already in the 70s of the 20th century started studies that challenged the treatment of the players in the economic game as rational robots. Kahneman won the Nobel Prize in Economics for his work in 2002 and Tversky would surely have won as well had he been alive at the time. Their pioneering work examined the money illusion and other psychological vulnerabilities, such as our tendency to regret losing $1,000 more than we would be happy to win the same amount.

A theme that runs through the entire theory of behavioral economics is psychological drives, many of which are illogical. These impulses lead to the formation of the bubbles and the severe landslides that follow them. Shiller, one of the leading researchers in the field, refers to this as "Animal Spirits" - a term coined by the economist John Maynard Keynes. The cyclicality of the business world, the normal ebb and flow of economic activity, depends on a basic sense of security. Without a sense of security, businesses and consumers will not communicate with each other in routine transactions. However, this confidence is not always based on a rational assessment. The animal soul - the gut feeling that it is indeed time to buy a house or a "dormant" stock (which is almost inactive but is assumed to have the potential to grow in the future) - is what brings people to a rule of excessive confidence and rash decisions in high tide times. Such feelings easily turn into panic as anxiety increases and the market changes direction. Making decisions based on emotion aggravates the impact of cognitive biases, such as not taking into account inflation due to the illusion of money, which cause illogical investments.

The importance of both emotional and cognitive biases in explaining the global crisis is evident in all the chain of events in the last ten years, during which the financial system is teetering on an abyss. The animal soul raised Internet stocks to unjustified heights during the "dot com" boom, and crashed their value to the ground after a few years. It once again played a role when irresponsible lenders took advantage of low interest rates and offered variable rate mortgages to borrowers whose ability to repay was in doubt (borrowers classified as "subprime"). In this regard, a phenomenon similar to the money illusion occurred: the borrowers who took out these mortgages did not correctly calculate what would happen if the interest rate rose, and this is exactly what happened in the middle of the current decade. The result was many foreclosures and the inability of many borrowers to meet their obligations. "Insured" mortgages, the debts of hundreds of thousands of home buyers that the banks converted into bundles of securities and sold, lost more than half of their value. The banks realized that their loan capital was dwindling. Credit, the lifeblood of capitalism, disappeared, and the world crisis began.

rules of thumb

Behavioral economics and the sub-field of "behavioral finance", which is more directly related to investments, illuminate more details regarding puzzling psychological habits in matters of money, and how these habits may have contributed to the current crisis. The money illusion is just one example of the irrational thought processes that economists examine. Heuristics, rules of thumb, which command us to react quickly in times of crisis, are perhaps a legacy from our Stone Age ancestors. Discretion and restraint are not an option when we are facing a woolly mammoth. When there is no wild animal in front of us, this heuristic can cause cognitive biases.

Behavioral economists have identified several biases, some of which have a direct link to economic bubbles. The "confirmation bias" means that people attach excessive importance to information that confirms their view. Give your opinion on the sharp increase in house prices, which resulted from the thinking that an increase in house prices is a safe bet. Due to the herd phenomenon, many were convinced of this. The "accessibility bias", which can cause decisions to be made based only on the latest information received, is one of the reasons why some newspaper editors avoided using the word "avalanche" in the fall of 2008, in an unsuccessful attempt to prevent a complete panic. The "hindsight bias", the feeling that something was known in the first place, is observed after the crashes: investors, home buyers and economists believe that the signs of the bubble were clear, even though they played a part in the increase in house prices.

Neuroeconomics, a close relative of behavioral economics, uses fMRI or other brain imaging techniques to find out whether these typical biases are just figments of the academic imagination, or whether they are actually at work in people's minds. Simulations have already confirmed the existence of the money illusion. The researchers are also interested in other questions, such as, for example, does talking about money or looking at it or even just thinking about it activate the reward and regret centers in the brain?

At the annual conference of the "Society for Cognitive Neuroscience" held in March 2009 in San Francisco, Julie L. Hall, a student of Professor Richard Gonzalez from the University of Michigan in Ann Arbor, presented a study showing that the willingness to take financial risks varies according to emotional signals, even the most subtle, and again The myth of the cold and calculated investor has been questioned. In the experiment, 12 women and 12 men viewed pictures of happy, angry and neutral faces. After looking at the happy faces, the "investors" noticed increased activity in the accumbens core, which is a reward center, and they consistently invested in riskier stocks and did not stick to bonds despite the relative security they provide.

"Happy faces" were frequently seen in the real estate boom that was a few years ago. The smiling face and cheerful speech of Carlton H. Sheets, host of the nightly economic advertising broadcasts on American television in the field of real estate, promised cash-strapped people a lot of money, credit or experience in real estate sales and ownership. Recently, the title in Sheets' plans changed to "real profits in foreclosures".

Behavioral economics not only tries to explain the behavior of investors. It also provides a framework for investment and policy-making, designed to help people avoid being tempted into emotional or ill-planned investments.

Today, at the beginning of Obama's term, this field is becoming more and more accepted. A group of leading researchers in the behavioral sciences advised Obama during the election campaign about motivating voters and donors. Cas Sunstein, a lawyer specializing in constitutional law, author of the important book Nudge at (gentle nudge) - that President Obama, it is said, also called him - was appointed head of the Office of Information and Oversight Affairs, which deals with government oversight, and other government officials who are behavioral economists or interested in the field are now occupying positions in the White House.

Sunstein and his co-author Nudge at, Richard Thaler, one of the fathers of behavioral economics, coined the term libertarian paternalism ("paternal" encouragement to make decisions without coercion) to describe the ability of government oversight to reduce people's tendency to make bad decisions. Reducing this tendency relies on a heuristic known as anchoring. Anchoring offers a way to look and think about things from the beginning, with the hope that this thought will translate into correct behavior. For example, you can encourage people to save more for retirement by automatically enrolling them in a pension plan rather than just offering them the option to enroll. "Employees are registered if they do not take any action on the matter, but they may choose not to be included in the program," explains Thaler. "This way it is guaranteed that mere distraction will not lead to poverty in old age." This idea finds expression in the Obama administration's plans to automatically enroll workers in a pension plan at their place of work.

Decision making is sometimes more complicated than just responding to a gentle nudge in one direction or another. In such circumstances, a "choice architecture" is required that helps to choose one of several options. When buying a house, for example, the buyer needs clearer information regarding the money illusion and similar factors. "When all the mortgages had a fixed interest rate for 30 years, choosing the best of them all was simple: the one with the lowest interest," says Thaler. "Now, when there are mortgages with variable interest rates, lure interest rates, balloon loans, early payment penalties and all, you need a doctorate in economics to find out the best of them all." A choice architecture will oblige the lenders to clearly "map" the options for the borrowers and reduce the burdensome paperwork involved in buying a house into two orderly columns: one lists the various fees, and the other indicates the interest payments. In a digital format, for example, it is possible to upload such columns and compare offers from different lenders.

In a similar spirit, Professor Shiller from Yale University outlines a complex strategy to prevent the exaggerations that characterize a bubble economy by educating to thwart mistakes in "economic thinking". Shiller suggests using new measurement units such as the unidad de fomento (UF) introduced by the Chilean government in 1967 and adopted by other Latin American countries. The UF protects against the illusion of money and allows the buyer and the seller to know if the price has actually increased or if inflation is deceiving them. This unit represents the price of a basket of goods in the market. The use of UF is so common that Chileans often quote prices in these units. "The linkage to the index in Chile is the most effective in all the countries of the world," says Shiller. "Home prices, mortgages, certain rents, child support payments and executive incentive options are often shown in these inflation units."

Shiller also advocates a new financial technique that may help fight bubbles. Supervisors are now scrutinizing the sophisticated financial instruments that were supposed to protect against defaults on the mortgage-backed securities that fueled the housing boom. Shiller claims that derivatives can help maintain a fair number of buyers and sellers in housing markets. Derivatives are financial contracts that are "derived" from some basic asset, such as a stock, a financial index and even its mortgage. They are supposed to protect against risk, but their speculative use was one of the causes of the credit crisis.

Although derivatives can be misused, in Shiller's eyes they are a careful "hedging" against bad economic scenarios. Home buyers and lenders in the housing market can use these financial instruments as insurance against a drop in price, thus ensuring sufficient liquidity and avoiding a halt in sales.

Will our help come from biology?

In the end, the solution to the current crisis will necessarily rest on new concepts regarding the actions of investors. One particularly creative approach is to correct flaws in existing economic theory by blending the old and the new. Andrew Lu, professor of finance at the Massachusetts Institute of Technology (MIT) and a hedge fund position, devised a theory that gives equilibrium economics and the efficient market hypothesis their due weight, but recognizes the existence of circumstances in which the classical theory does not correctly describe what is happening in the market. This theory is an attempt at a broad integration of evolutionary theory, classical economics and behavioral economics. That is, Lu's approach is based on the idea that the integration of Darwinian natural selection into the simulation of economic behavior can help generate useful insights regarding the way markets operate, and provide more accurate than usual predictions regarding the behavior of financial actors, individuals and institutions alike.

Similar ideas have already occurred to economists. Already in 1898, the economist Thorstein Veblen proposed to see economic theory as an evolutionary science; And even earlier, Thomas Robert Malthus had a profound influence on Darwin himself with his musings on the "war of existence".

Just as natural selection assumes that certain organisms are suited to survive in a certain ecological niche, so the "adaptive market hypothesis" sees the various actors, from banks to mutual funds, as "species" competing for economic success. It also assumes that sometimes these players invest ("competitors") according to heuristics that are pulled from the hip, as described by behavioral economics, and sometimes they take irrational strategies, such as increasing the risk during a sequence of losses.

"Economists suffer from a deep psychological disorder that I call 'the envy of physics'," he says. "We would like to describe 99% of economic behavior with three simple laws of nature, but the truth is that economists have 99 laws that describe only 3% of behavior. The economy is a distinctly human enterprise, and therefore it must be viewed in the broader context of competition, mutations and natural selection, or in short evolution."

If investors have an evolutionary model to consult, they may be able to adapt to changes in the risk profiles of different investment strategies. But perhaps the most important advantage of Lu's simulation is the ability to detect when the economy is out of equilibrium. If this is found to be the case, it will be a warning to regulators and investors that a bubble is getting inflated, or a bubble is about to burst [see box on the left].

An adaptive market model can take into account information about changes in market prices, similar to how people adapt to a particular ecological niche. The model will be able to go further and conclude whether today's prices affect tomorrow's prices - a situation that suggests that investors are driving like a herd, in the language of behavioral economists, and is a sign of an upcoming bubble. Thanks to such modeling, the regulations will also be able to "adapt" to changes in market trends and deal with the "systemic" risks in advance, which the usual risk assessment models do not protect the markets from. Lu advocates the establishment of a "Capital Market Safety Council", a body similar to the institutions that investigate aviation accidents. The Council will collect data regarding the dangers of the past and the dangers faced by the financial system, and these will serve as a necessary basis for creating an adaptive market model.

Since neuroscience reveals the roots of investors' behavior, it is likely that new evidence will be found that the concept of "homo economicus" is fundamentally wrong. A rational investor shouldn't care if she had $10 million and lost $8 million, or had nothing and made $2 million. The end result is the same.

But behavioral experiments repeatedly show that humans (and other primates) hate losing more than they crave winning. This is an evolutionary legacy that causes animals to store food and examine situations with discretion before risking an encounter with a predator.

People whose sense of loss does not outweigh the joy of gain are autistic. Autism is a disorder in social interactions. It was found that autistic subjects often listen to pure logic when comparing gains and losses, but this apparent rationality may, in itself, indicate abnormal behavior. "Adherence to logical and rational principles that yield an optimal economic decision may not be biologically natural," says Colin P. Kamer, a professor of behavioral economics at Caltech. The improvement of psychological understanding, which the neuroscientists are working on, has the power to change forever our basic assumptions regarding the functioning of entire economies as well as the understanding of the motives of each and every player in the economic arena, the people who buy houses or shares and have difficulty determining whether the value of the dollar today is equal to the value it had yesterday.

Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich. Jason Zweig. Simon Schuster, 2007.

The Mind of the Market. Michael Shermer. Times Books/Henry Holt, 2008.

The Subprime Solution: How Today's Global Financial Crisis Happened and What to Do about It. Robert J. Shiller. Princeton University Press, 2008.

Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism. George A. Akerlof and Robert J. Shiller. Princeton University Press, 2009.

Nudge: Improving Decisions about Health, Wealth and Happiness. Richard H. Thaler and Cass R. Sunstein. Penguin Books, 2009.

2 תגובות

  1. The most important subject that business managers do not study and should have taken at least one course from is: psychology

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