Tuesday, August 11, 2009
Let’s review the evidence:
In late October last year, former Fed Chairman Alan Greenspan told Congress that “those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”
Last week, I entered an ATT&T store with the sole purpose of updating my plain vanilla account. I left with an iPhone. I am in a state of shocked disbelief.
Classical economics holds that, when it comes to money, individuals and markets make rational decisions. Ha!
Okay, what is going on? An article by Gary Stix in the July Scientific American offers some insight. In the wake of the worst financial meltdown since the Great Depression, classical economic dogma is being exposed to serious scrutiny. In the meantime, behavioral economics is getting a second look.
Classical theory makes sense when markets are in a state of relative equilibrium. Like the brain or the environment, the economy is a nonlinear self-regulating system with its own internal logic. Even when things go wrong, the invisible hand of the market place has an uncanny way of setting things right.
Indeed, classical economics would work perfectly if only people weren’t involved. Unfortunately, classical economics can’t account for stupid human tricks. And sometimes when things go wrong, markets fail to self-correct.
Enter behavioral economics. According to Scientific American:
“Emotion-driven decision making complements cognitive biases - money illusion’s failure to account for inflation, for instance - that lead to poor investment logic.”
In one experiment, subjects made financial deals as their brains were being scanned. When presented with a result that only looked like a gain if you didn't think things all the way through, the ventromedial prefrontal cortex (VMPFC) lit up. The VMPFC is wired into risk and reward, as are the more primitive nucleus acumbens and amygdala, which mediate greed and fear, respectively.
In other words, high emotion and faulty cognition have always been a recipe for disaster, whether in choosing a mate or making an investment. Some of the cognitive biases we are prone to include overconfidence (we all think we’re better than average), herding (tendency to follow crowds), and availability (giving undue weight to recent events).
Scientific American quotes Andrew Lo of MIT: “Economists suffer from a deep psychological disorder that I call ‘physics envy.’ We wish that 99 percent of economic behavior could be captured by three simple laws of nature. In fact, economists have 99 laws laws that capture 3 percent of behavior.”
And there we have it.
What was going on in Alan Greenspan’s mind when he thought that markets could self-regulate forever? What was going on in my mind when I bought an iPhone?