Scientific American takes a look at the “worst economic crisis since the Great Depression,” from the perspective of reassessing how financial markets work relative to how people make decisions about money

The Science of Economic Bubbles and Busts:

“Even people who do not use illicit drugs or get shot in the head have to contend with the reality that some of the decisions cooked up by the brain’s frontal lobes may lead them astray. A specific site within the prefrontal cortex, the ventromedial prefrontal cortex (VMPFC) is, in fact, among the suspects in the colossal global economic implosion that has recently rocked the globe.

The VMPFC turns out to be a central location for what economists call “money illusion.” The illusion occurs when people ignore obvious information about the distorting effects of inflation on a purchase and, in an irrational leap, decide that the thing is worth much more than it really is. Money illusion may convince prospective buyers that a house is always a great investment because of the misbegotten perception that prices inexorably rise. Robert J. Shiller, a professor of economics at Yale University, contends that the faulty logic of money illusion contributed to the housing bubble: “Since people are likely to remember the price they paid for their house from many years ago but remember few other prices from then, they have the mistaken impression that home prices have gone up more than other prices, giving a mistakenly exaggerated impression of the investment potential of houses.”

Economists have fought for decades about whether money illusion and, more generally, the influence of irrationality on economic transactions are themselves illusory. Milton Friedman, the renowned monetary theorist, postulated that consumers and employers remain undeluded and, as rational beings, take inflation into account when making purchases or paying wages. In other words, they are good judges of the real value of a good.

But the ideas of behavioral economists, who study the role of psychology in making economic decisions, are gaining increasing attention today, as scientists of many stripes struggle to understand why the world economy fell so hard and fast. And their ideas are bolstered by the brain scientists who make inside-the-skull snapshots of the VMPFC and other brain areas. Notably, an experiment reported in March in the Proceedings of the National Academy of Sciences USA by researchers at the University of Bonn in Germany and the California Institute of Technology demonstrated that some of the brain’s decision-making circuitry showed signs of money illusion on images from a brain scanner. A part of the VMPFC lit up in subjects who encountered a larger amount of money, even if the relative buying power of that sum had not changed, because prices had increased as well.”

Fascinating stuff . . .


The Science of Economic Bubbles and Busts
Gary Stix
Scientific American Magazine, July 2009

Category: Psychology

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15 Responses to “The Neuroscience Science of Bubbles and Busts”

  1. globaleyes says:

    It’s simple: the entire world got a VMPFC-style sugar rush at the same time, leaving no one to correct things untl Mr Market took control and tilted the whole thing in the other direction. We might be here for a while because the dust will take a long time to settle.

  2. danm says:

    My dad is the perfect example. He kept on bragging about how much money he made on one of his houses.

    He bought it at the trough in 1978 after the referendum and sold it at the peak. Annualized it came to a return of 6.5% per year. Take away taxes and maintenance and you end up with a return of less than 4.5%. It is nontaxable but still not spectacular by any stretch.

  3. danm says:

    As you do more and more research into neuroscience, you start questioning free will. Our brain convinces us that we are in control but in reality we are a slave to our genetics, environment and past experiences.

    And I’ve found that those who are the most appalled at hearing this concept are Americans. For some reason, Americans are more attached than others to the concept of free will.

    I remember reading about some research where rich and poor were asked whether or not it was luck or talent that made them successful or not. Obviously, the rich said talent and the poor said bad luck. Interestingly, research has demonstrated that the state of the economy when one graduates is the strongest predictor of ones wealth at retirement.

    So I figure that Americans are still bathing in their success and still thoroughly convinced that they have everything under control.

    You know that little engine that could…

  4. constantnormal says:

    “Interestingly, research has demonstrated that the state of the economy when one graduates is the strongest predictor of ones wealth at retirement.”

    How fortunate for those who graduated in 2007, 1999 or 1929!

    And how sad for those who graduated in 1930, 1975, 2001, or 2009 …

    I guess I would have to examine that research rather closely, as I cannot find any subjective correlation between year of graduation and retirement prosperity, or any hint of a 30-year economic cycle.

  5. constantnormal says:

    I suppose it could be an inverse predictor, with those who graduated during “hard times” having the responses to those times burned into their minds as the plasticity begins to wane … but I would still have to see the numbers.

  6. danm says:

    constantnormal :

    I’m looking for it. I’ve seen it mentioned a couple of times over the last decade but can’t remember who produced it. And I probably have to replace the “strongest predictor” with “important predictor”.

    What I remember reading was that when graduates enter the work force in a recession they get lower wages than those entering in a boom. And by the time they reach 30, many of those salaries still don’t match those of the new entrants salaries despite increases. That difference makes a huge difference over an entire career.

    For example, in the early 90s, engineers were starting around 30K. By the end of the 90s the new starting engineers were starting with 60K while the 30 year olds were probably just starting to touch 60K at 30.

  7. danm says:

    The Career Effects Of Graduating In A Recession

  8. ben22 says:

    I love this kind of information. Very interesting stuff. Some that study socionomics are predicting a 100 year bear market due to the sea change in social mood, which drives markets, and the news, not the other way around.

    Would love to see more on this topic BR.

  9. alfred e says:

    I used to be a big fan of Scientific American. No longer. I still subscribe, but not for much longer. And I have voiced my objections to them. They have gone beyond the realm of simply reporting new science to the layman to a cross between Popular Science and Sierra Magazine. Overflowing with MSM liberal propaganda positioned as objective science.

    For example, who is author Gary Stix? Usually the articles carry brief bios of the authors. So and so is a professor of … at … There was no mention of who Gary Stix was. If you Google Gary Stix, you will find out. More interestingly, you will also get a list of his contributions to the magazine.

    I found the article manipulative and insulting. It effectively puts the blame for the housing bubble squarely on the shoulders of the homebuyer. Sure, they ate the propaganda they were fed and bought into the market. Who could stay out when the terms were so favorable? Is that irrational?

    The other side of the coin is behavioral economics, at its core, is really meant to be manipulative. Much akin to George Lakof’s work for the Democratic Party.

    The work of Kahnemann and Tversky has been around for decades. Nothing new there. It’s a huge logical leap between their work, the recent neuroscience study of brain activity, and the conclusion that the housing bubble was simply the manifestation of our impulsive buyer side.

  10. danm says:

    Is that irrational?
    What is the difference between irrational and rational anyway?

    Is it the soundness of the decision or is it the fact that you rationalize before making a decision.

    Garbage in, garbage out. What if you are rationalizing using a bad aset of data?

    A large part of our decsion making is not even made consciously anyway. Secondly, the world is complex and our brains are selective so it is impossible to have the perfect data when making life decisions.

  11. Onlooker from Troy says:

    It is fascinating but perilously close to abdicating any responsibility for our actions. We walk a fine line between understanding our weaknesses and primal urges, and accepting our responsibilities as thinking, reasoning (or at least our ability to do so) humans that can make choices to avoid self-destructive behaviors.

    We need to understand the science of this, but not use it to let ourselves off the hook for being stupid and greedy. Tricky balance to that, no doubt.

  12. alfred e says:

    Sorry about the earlier snarky rant. Scientific American just happens to be one of my hot buttons.

    Rational expectations was one of the approaches a few decades back as well. If I’m not mistaken there have been some Nobel Prizes awarded for showing the “irrational economic behavior” in a seemingly rational world.

    Where’s MEH? He could probably cite chapter and verse various mysterious programs investigating mind control.

    And there have been some really good recent articles about the boundary between conscious and subconscious.

    Here’s a question. Suppose the government is spending tons of money investigating the neuroscience of how emotion, reason, instinct,impulse define behavior and decisions.

    Will that ultimately be applied toward stimulating consumption/good citizenship, being able to monitor for early signs of non-compliance and take early corrective action, or further enabling individuals to improve their decision making processes?

  13. danm says:

    It is fascinating but perilously close to abdicating any responsibility for our actions.
    I don’t see it that way at all.

    I believe that e person is a slave to his/her genetics, environment and past experiences. I tend to believe that when an accident happens or a crime is committed, the outcome could not have been any different unless many of the a priori variables had been different: the environment, physiology, past experiences…

    Because we humans think we have free will, we’d like to think that the crime could have been averted and that the criminal really had a choice at the moment of the crime. We also like to believe in justice when we have been wronged and that probably reinforces our belief in free will.

    I think our societies are based on faulty systems, entirely based on the existence of free will. In the middle ages, they used to put animals on the stand, so obvioulsy our logic has been changing throughout the centuries and will continue to change as we find out more about the brain.

    If free will is a farce, then our legal system would need to be totally transformed. We would need to revisit the difference between crime and accident for one. It would give a new meaning to being proactive. You would have to weed out the genes, the environmental factors and experiences that promote undesirable actions. Obviously, we are not advanced enough technologically and in our knowledge of the brain to do this. And because of this, it feels much more comfortable to hold on to our notion of free will. It’s so much easier to say that he/she did it. It’s her/his fault. It suits our current level of knowledge and our inherent desire for simplicity and justice.

    But even without being “responsible”, it does not negate the fact a crime was committed and that a person can still be deemed a menace and need to be restrained.

  14. constantnormal says:

    @ danm 9:20 am

    I’m still skeptical. I graduated — as an engineer, as luck would have it — in 1974, into the effects of the 1973 Arab Oil Embargo on GM. I was one of two engineers in the department I was working in with less than 20 years seniority. That was a backup employment position, as the research department I had been aiming at winked out of existence and was folded into the rest of the general engineering staff of that division of GM. I do have some actual experience regarding starting a career in less-than-optimal circumstances.

    So I transferred into the IT organization, and made a career there. Despite having graduated into less-than-optimal economic times (the Nixon insane (perhaps I have those words reversed) wage-and-price controls was soon to follow), I saw my salary rise in accord with the trend suggested by the author of the article you offered. I never, however, saw a year of salary decline anytime within the initial decade of employment, despite having started during what was (up until now) the “worst recession since the Great Depression”. As the author states, “luck matters”. And while toward the end of my career (I retired early at 54), new hires were getting much larger compensation packages than I did when I was starting out, when you inflation-adjust those packages, it was not so different. But that’s only a single data point.

    Like I said, I’d have to see the details behind the study. The mere fact that someone ran a study and “demonstrated” result XYZ proves very little, as the medical establishment manages to produce conflicting studies with frightening regularity. And in the realm of economics, failed theories are a dime a dozen, with government studies being among the most suspect of all. Studies must stand the test of time and have their conclusions challenged many times before they should be taken with other than a grain of salt. They’re better than unsubstantiated opinion, but until they have withstood several challenges, not much better, IMHO.

    Another way of examining the question of “retired wealth” is to examine the savings and spending habits engendered by having started out in tough times, vs starting one’s career in the middle of the 1990′s, for instance, perhaps at a fledgling dot-com company. Those folks started at the top, and I suspect are now a significant step lower than where they were when they started out. If their spending and savings habits stuck with them from their days of “bilk and money”, then they are most assuredly poorer today.

    There’s more to acquiring wealth than salary. The NBER study (at least as described in the linked page) apparently only examined income data, not asset accumulation, of only Canadian graduates over a single period precisely covering the years from 1982-1995 (or 1976-1999, if you want to include non-overlapping areas of coverage from their data sources). If would have been a lot stronger study if the entirety of the 20th century had been examined, and a larger population of subjects had been studied. Certainly more than one or two boom and bust periods. And the biggest item missed (and I admit that I see no good way to collect this data) is their net worth at retirement.

    I remain skeptical.

  15. kaleberg says:

    Every time things go bust every starts blathering about bubble logic and how our brains get all scrambled and all that wealth we thought we had was just an illusion and so on. As best I can tell it is all mindless blather, probably because our brains got all scrambled and all that.

    To start with, how can an observer distinguish a boom and a bubble, especially since most booms overshoot and collapse much as all bubbles do? When exactly do the prices go from high, in anticipation of increased yield, to outrageous, clearly beyond any reasonable prospect? Isaac Newton got hooked on the South Sea Bubble. He actually bailed, having made a fair bit of money, but then got in again and got creamed along with everyone else. He was supposed to be some kind of genius, and with his position at the mint, clearly an insider.

    To be honest, I have my own theory. If you consider every investment opportunity as a simple Ponzi scheme, the only thing that matters is getting out before the scheme runs out of suckers. It is easy out here in the sticks, we have a local billboard that is used to indicate that the big guys are running out of suckers, and are even interested in whatever slim pickings they can find out here. I could tell the tech boom had passed when the sign started to tout investing in the stock market, and I could tell the real estate boom had passed when the sign started to tout investing in real estate. Is this all there is to it? Just drive around some poor, rural county and check the billboards? There has to me to all this investing and economics stuff.

    I really don’t think bubbles have to do with a lack of logic. It actually is possible to make money in the stock market or real estate. When one sees prices rising, and rising, and rising, it makes sense to join in the party. That is not irrational at all. College graduates make more money than high school graduates who make more money than drop outs. Is this real logic or just bubble logic? Which way are you going to argue with your kid? Of course, it helps to keep track of the music when the party game happens to be musical chairs.