What caused the collapse of Wall Street? The bait of gain. Lax regulations. The panic. And perhaps the biological make-up of investors’ brains. Eight years ago, a handful of brain scientists began using MRI scans, psychological tests and novel analysis of brain anatomy in an attempt to overturn economic theories that assume that people have always acted rationally when it comes to financial decisions. To understand the market, these researchers say, you need to get inside people’s heads. They called their new field neuroeconomics.
If it were necessary to demonstrate that markets can be unpredictable, irrational and cruel, these last few weeks would give us irrefutable proof. Bear Stearns and Merrill Lynch were quickly absorbed into emergency mergers. The government bailed out Fannie Mae, Freddie Mac and AIG. Lehman Brothers is bankrupt. So, do these neuroeconomists shed any light on what went wrong? Surprisingly, yes.
“Fear associated with group effect leads to panic,” says Gregory Berns, a neuroeconomist at Emory University. “Of course it’s based on biology. At the heart of the financial market turmoil are securities that were covered by very risky mortgages. The theory was that slicing and reselling the debt portfolio as securities would reduce the risk significantly. But rating agencies were compensated by mortgage-backed securities issuers, and neuroeconomics says that created big problems. “You don’t get this wrong just out of stupidity,” says George Loewenstein of Carnegie Mellon University. “It’s when you combine stupidity with the prospect of gain that you make mistakes of this magnitude. »
Consider the next research by Loewenstein, Weber and Roberto John Hamman of Carnegie Mellon University. They paired volunteers as partners. One gives $10 to a partner and tells him to split it as he sees fit. On average, the partner keeps $8 and gives $2. Then the researchers start the game over again. This time, the decision maker pays an “analyst” to figure out how to distribute the money fairly. The game continues in several parts and the decision maker can dismiss the analyst. With this change, the decision maker takes everything. Paying someone else to ensure assets are distributed fairly actually makes things less fair.
Colin Camerer, an economist at Caltech, blames “diffusion of responsibility” for causing the problems. His own research identifies another problem: neither investors nor bankers were in a position to consider the worst-case scenario. Camerer conducted experiments in which two people engage in a game of negotiation about how to split $5. But each time they fail to agree, the value of the pot will go down. Traders can check the total fund value by clicking on the colored boxes on a computer screen. But only 10% of them looked to see what will happen in the worst case.
To make matters worse, hedge funds boasted strange earnings, making it seem like the impossible was possible. “But some studies show that these results were probably overestimated by information retention,” Camerer said.
Brain imaging studies show that investors, in general, have become more accustomed to high returns, and therefore take more and more risk when the market is up – and then the economic bubble forms and shareholders start selling like crazy. One reason: investors fear losing more than they hope to gain. According to a 2007 report, researchers used MRI scanners to monitor people’s brains as they decide whether or not to take a risk with a 50/50 probability. The gains cause the brain to respond by illuminating the areas from which dopamine is released (from the chemistry stimulated by Prozac and Zoloft); the losses reduce the activity of these same zones. Researchers can predict what people would do based on the level of increased activity.
Dreadful, the anticipation of a loss to come, is another powerful force. Berns showed that people differ in how they respond to pain. He applied electric shocks to people in an MRI machine, then gave them the option of either getting an intense shock immediately or a less intense shock later. People whose brains began to light up in areas associated with pain in advance were more likely to decide to end the pain immediately. They would be among the shareholders who sold their shares.
So what should a regulator do? One argument against the bailout is moral hazard – the idea that if you free the banks now, the next bankers will take on even more risk. Camerar points out that people are naturally short-sighted. “People with health insurance spend more on medical care,” he says, “but people who rent cars don’t have more accidents because there are more immediate risks, such as injuries. bodily”. So far, the government’s attempts to suppress the risk reinforce the idea that things are very badly wrong. “If you tell someone not to think about white elephants,” Loewenstein notes, “they do just that.”
On the other hand, “purging the markets of these mortgage-backed securities, as the government’s plan has tried to do, could reinforce investor panic,” said Richard Peterson of MarketPsy Capital, which is trying to set up the research. in neuroeconomics at a $50 million hedge fund. “Things are unrecognizable,” says Peterson. “It is the X factor that is causing the spread of risk aversion. »