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The Neuroscience Science of Bubbles and Busts
Posted By Barry Ritholtz On June 29, 2009 @ 6:36 am In Psychology | Comments Disabled
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
“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 
Scientific American Magazine, July 2009
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 The Science of Economic Bubbles and Busts: http://www.scientificamerican.com/article.cfm?id=the-science-of-economic-bubbles
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