Fear, Greed, andFinancialCrises:
ACognitiveNeurosciences Perspective*
†AndrewW.Lo
FirstDraft: August28,2011
LatestRevison: October12,2011
Abstract
Historical accounts offinancial crises suggest that fearand greed arethe common
denominators ofthese disruptive events: periods of unchecked greed eventually lead to
excessive
leverageandunsustainableasset-pricelevels,andtheinevitablecollapseresultsinunbridled fear,
which must subside beforeanyrecovery is possible. Thecognitive neurosciences may
providesomenewinsightsintothisboom/bustpatternthroughadeeperunderstandingof the
dynamics ofemotion and human behavior. In this chapter, I describe some recent
researchfromtheneurosciencesliteratureonfearandrewardlearning,mirrorneurons,theory
ofmind,andthelinkbetweenemotionandrationalbehavior.
Byexploringtheneuroscientificbasisofcognitionandbehavior,
wemaybeabletoidentifymorefundamentaldrivers
offinancialcrises,andimproveourmodelsandmethodsfordealingwiththem.
*Prepared
for J.P. Fouque and J. Langsam, eds., Handbook on Systemic Risk, Cambridge University Press.
ResearchsupportfromtheMITLaboratoryforFinancialEngineeringisgratefullyacknowledged. I thank Jayna
Cummings and Hersh Shefrin for helpful comments and discussion. The views and opinions
expressedinthisarticlearethoseoftheauthoronlyanddonotnecessarilyrepresenttheviewsandopinions of
AlphaSimplex Group, MIT, any of their affiliates oremployees, or any ofthe individuals acknowledged above.
†Harris&HarrisGroupProfessor,MITSloanSchoolofManagement,andChiefInvestmentStrategist, AlphaSimplex
Group, LLC. Please direct all correspondence to: Andrew W. Lo, MIT Sloan School of
Management,100MainStreet,E62–618,Cambridge,MA02142.
Contents
1 Introduction 1 2 A Brief Historyofthe Brain 4 3 Fear 7 4 Greed 12 5 Risk 17 6 Rationality
21 7 Sentience 28 8 Interactions 31 9 PolicyImplications 36 10Conclusion 39 References
44
1 Introduction
InMarch1933,unemploymentintheUnitedStateswasatanall-timehigh. Over4,000banks
hadfailedduringtheprevioustwomonths. Breadlinesstretchedaroundentireblocksinthe largest
cities. The country was in the gripoftheGreatDepression. This was the context in which
Franklin Delano Roosevelt delivered his first inaugural address to the American
peopleasthe32ndpresidentoftheUnitedStates. Hebeganhisaddressnotbydiscussing
economicconditions,norbylayingouthisproposalforthe“NewDeal”,butwithapowerful
observation that still resonates today: “So, first of all, let me assert my firm belief that
theonlythingwehavetofearisfearitself—nameless,unreasoning,unjustifiedterrorwhich
paralyzesneededeffortstoconvertretreatintoadvance”.
Seventy-five years later, these words have become more relevant than FDR could ever
have imagined. The current set of crises—the bursting of the U.S. real-estate bubble, the
unprecedentedhomeownerdefaultsandlossesbymajorfinancialinstitutionsthatsecuritized and
leveraged these loans, the U.S. debt-ceiling debacle and political stalemate, and the
European sovereign debt crisis—is, in essence, all about fear. Since money was invented,
fortunes have always been made and lost by intrepid investors, but the current crisis feels
different because of the sheer magnitude and complexity of the reported losses and the
apparentrandomnessoftheirtimingandvictims.
Fromanarrowperspective,fearsofinsolvencyinthebankingindustryinAugust2007, alongwith
thesudden breakdown ofinterbank lending andshort-term financing, were the
initialflashpointsofthecrisis. However,thesefearsweretriggeredbythenationaldecline in U.S.
residential real estate which, in turn, caused mortgage-related securities such as
collateralizeddebtobligations(CDOs)tolosevalueandbecomehighlyilliquid. Thefailure of large
credit default swap (CDS) counterparties, the apparent inaccuracy of AAA bond
ratings,regulatorylapsesandforbearance,politicaleffortstopromotethe“homeownership
society”, andtheimplicitgovernment guaranteesofFannieMaeandFreddieMaccanalso
becitedassignificantfactorsincreatingthecrisis. Althoughthe“blamegame”islikelyto
continueforyearstocome, thefactthatnoprosecutionsorarrestshavebeenmadeinthe
wakeofthecrisisof2007–2009suggeststhattherearenosimpleanswersastowhoorwhat
wasresponsible.
1
But even a cursory review of expansive histories of past crises such as Kindleberger’s
(1978) classic and Reinhart and Rogoff’s (2010) more recent definitive treatise suggests a
common originforall financial bubbles andbusts: fearand greed. Aperiodofunchecked greed
leads tounsustainable asset-price levels, andthe inevitable price decline ushers in a period
of unbridled fear. The broader the participation in the growth of the bubble, the
deepertheimpactontherealeconomybecauseofthenumberofhouseholdsaffectedbythe
bubble’sbursting.
Therelevanceofhumanbehaviortofinancialmarketsandeconomicaffairsisnotanew idea.
JohnMaynardKeynes(1936)observedoversevendecadesagothateconomicdecisions were
due more to “animal spirits” than carefully weighed probabilities, and that financial markets
operated more like beauty contests than efficient price-discovery platforms.
However,despitetheearlysuccesses ofKeynesianmacroeconomics,themorerecentdominance
of the rational expectations school ofthought has left little roomfor animal spirits in the
policymaker’s toolkit. Oneofthefewpositive consequences oftherecentfinancialcrisisis the
realization that the current approach tomeasuring andmanaging systemic risk in the
financialsystemisinadequate,andthatpolicymakersneedabroaderintellectualframework.
Inthischapter,Ihopetoservethatneedbyexploringtheneuroscientificunderpinnings
ofhumanbehavior,particularlythosebehaviorsmostrelevanttosystemicrisk. Iffearand greed are
the key drivers of all financial crises, then a better understanding of how the brain produces
these behaviors may eventually allow us to formulate more effective
policiestomanagetheirconsequences. Forexample,neuroscientistshaveshownthatmonetary
gain stimulates the same reward circuitry as cocaine—in both cases, dopamine is released
intothenucleus accumbens. Similarly, thethreatoffinanciallossapparentlyactivatesthe
samefight-or-flightresponseasaphysicalattack,releasingadrenalineandcortisolintothe
bloodstream,resultinginelevatedheartrate,bloodpressure,andalertness. Thesereactions are
hardwired into human physiology, and while we’re often able to overcome our biology
througheducation,experience,orgeneticgoodluckduringnormalmarketconditions,under more
emotionally charged circumstances, the vast majority of the human population will
behaveinlargelypredictableways.
ThisneurophysiologicalbasisforKeynes’sanimalspiritshasimportantimplicationsforregulatoryre
form,includingtheneedforpath-dependent
andadaptivecapitalrequirementsandleverageconstraints,moreaccurateandtimelymea2
suresofsystemicrisksoregulatorsandmarketparticipantscanrespondappropriately,and more
direct feedback loopsbetween policies and outcomes thatwill enhance ourcollective
intelligencethroughreinforcementlearning.
Todevelopthiscognitiveneurosciencesperspectiveoffinancialcrises,IbegininSection 2 with
a brief history of our understanding of the brain, which was surprisingly primitive until quite
recently. Of course, the brain is extraordinarily complex, so by necessity we
havetonarrowourfocustojustthosecomponentsthataremostrelevantforourpurposes:
fear,greed(or,itsclosecomplement,pleasure),riskpreferences,rationality,andthevarious
combinations of these elements. In Section 3, I describe fear learning and the amygdala,
one of the most important neural components of financial crises. In Section 4, I turn to
theneuralmechanisms mostcloselyassociatedwiththebuild-upofbubbles—pleasure and
greed—andshowhowtheadaptivenessofneuralsystemsforrewardandpunishmentmakes
crisesvirtuallyunavoidable. ThistendencyisspelledoutmoreclearlyinSection5,whichis
devotedtotheeffectsofriskondecision-making,whichispredictableand,inthecaseofrogue
traders,oftendisastrous. Toomuchemotioncantriggerirrationalbehavior,butsocantoo
littleemotion,andinSection6,Idescribeadefinitionofrationalityfromtheneurosciences
perspectivethat’sradicallydifferentfromtheeconomicnotionofrationalexpectations,the
differencehingingcriticallyontheuniqueroleofemotion. ThemechanismsofSections3–6
allrefertoindividualbehavior,butinSection7,Iexploretheimpactofsocialinteractions
throughtheneurophysiology ofmirrorneurons, braincells dedicated toallowing othersto
“feelyourpain”. Alloftheseneuralcomponentsinteracttoproduceintentionsandactions, and in
Section 8, I describe some properties of the “executive brain” in orchestrating the
complexityofwhatweobserveashumanbehavior. Iconsiderthepublicpolicyimplications
oftheneurosciencesperspectiveinSection9andarguethatoneofthemostimportantaspects of
government and regulation is to protect ourselves from our own behavioral patterns by
moderatingtheextremesoffearandgreed. IconcludeinSection10withsomethoughtson
thepotentialrolethatthecognitiveneurosciencescanplayinfinancialeconomics.
3
2 A BriefHistoryoftheBrain
Itseemsobviousthatabetterunderstandingofthebrainshouldleadtoabetterunderstandingofecon
omicdecision-making. Ourownsubjectiveexperienceashumanbeingsstrongly
suggeststhatwedon’talwaysactrationallyorinourownself-interest. Undertheinfluence of strong
emotion or stress, or even for no reason we can consciously pinpoint, we’ve all
madedecisionsthatwelaterregret. Inthetwenty-firstcentury,wenowknowthatthought
takesplaceinthebrain,throughtheinterconnectionsofnerves,mediatedbychemicalsand
electricity, even ifwe’reunsureoftheexactdetails. Itseems eminentlylogicalthenthata
betterunderstandingofthebrainwouldnecessarily leadtoabetterunderstanding ofhow humans
make economic decisions, just as a better understanding of the heart led William
Harveytodiscoverhowthebloodflowsthroughthehumanbody.
However, this understanding of the brain is a very new development in science. For
decades, ifnot centuries, the study ofeconomics has been more highly advanced than the
study of the brain. Adam Smith sought to explain human behavior in terms of our inner
psychology, yet there was noway hecould measure themoralsentiments he soeloquently
described. Aslateas1871,theBritisheconomistWilliamStanleyJevonscouldwrite:
1Farbeitfrommetosaythatweevershallhavethemeansofmeasuringdirectly
thefeelingsofthehumanheart. Aunitofpleasureorofpainisdifficultevento
conceive;butitistheamountofthesefeelingswhichiscontinuallypromptingus
tobuyingandselling, borrowingandlending, labouringandresting, producing and
consuming; and it is from the quantitative effects of the feelings that we
mustestimatetheircomparativeamounts.
Moderneconomicsemergedundertheassumptionthattheinternalprocessesleadingtoan
economic decision could never be directly measured. This assumption led to the ideas of
revealedpreferenceandutilitytheory,whichstillformthebedrockofmodernmicroeconomics
today.
Incomparison,thescientificstudyofthebrainwouldremainbackwardsforquitesome time.
DuringJevons’s time, even theideathatnerves were composedofindependent cells
wasstillindoubt. Thisissurprisingtoustoday,whenchildren’sbooksandprescriptiondrug
commercials routinely contain illustrations of neurons, admittedly sometimes fanciful, and
1Jevons(1871,pp.13–14).
4
howtheywork. IttookthelaboratoryadvancesoftheItalianpathologistCamilloGolgiand the close
observations ofthe Spanish pathologist Santiago Ram´on y Cajal to demonstrate the validity
of the “neuron theory”, using state-of-the-artmicroscopic techniques fortheir time. Golgi and
Ram´on y Cajal were quickly honored for their work, jointly winning the
NobelPrizeinPhysiologyorMedicinein1906(althoughGolgihimselfwasnotabelieverin
neurontheory)!
2In
the same way, most scientists were skeptical that the brain contained specialized
regions for different purposes until remarkably late in the scientific era. Today, we refer
casuallyto“speechcenters”or“visualcenters”,anditisnaturalforustospeculateifthere
isaparticularpartofthebrainwhichassesseseconomicvalueorfinancialrisk,butformuch
ofthemodernera,thiswouldhavesoundedlikenonsensetoaneducatedperson. Thiscan
beexplainedinpartbythesociologyofscience. Inthemid-eighteenthcentury,theSwedish
philosopherEmanuelSwedenborgcorrectlydescribedthespecializednatureofthecerebral
cortex,linkingitsstructuresofnervefiberstotheirfunction,butSwedenborgwasalsoknown
forhisreligiouswritingsaboutdreamsandangels(thereisstillaSwedenborgChapelonthe
Harvardcampus),andhishypothesiswasignoredfordecades.Meanwhile,thephysiologist Franz
Joseph Gall also believed that different parts of the brain had different functions; however,
he believed that these were reflected in the external shape ofthe skull. This led
tothepseudoscienceofphrenology,throughwhichone’spersonalitycouldbedeterminedby
examiningthebumpsonone’shead,atheorywhichwasquitepopularinthefirsthalfofthe
nineteenthcentury. Eventually,thisdisciplinecameintodisrepute,creatingacertaindegree
ofskepticism-by-associationfortheheterogeneousnatureofthebrain.
Thisskepticismwasslowlyoverturnedinthenineteenthcentury,principallythroughthe study of
individuals with brain tumors, lesions, or other head injuries. One of the most celebrated
cases was of a young New Hampshire man named Phineas Gage, who had an iron rod
pass under his upper jaw and through the topof his head during arock-blasting
accidentintheconstructionoftheRutland&BurlingtonRailroadin1848. Gagesurvived
andrecoveredfromthishorrificaccident—wellenoughtolaterbecomeastagecoachdriverin
Chile!—buthispersonalityandhabitschangedmarkedly. Gage’scaseisespeciallyinteresting
fromaneconomicpointofview. Inthewordsofhisdoctor,writingseveralyearsafterGage’s
2Finger(1994,pp.29–30).
5
3death,“Theequilibriumorbalance,sotospeak,betweenhisintellectualfacultiesandanimal
propensities,seemstohavebeendestroyed”. Beforetheaccident,Gagewas“ashrewd,smart
businessman, very energetic and persistent in executing all his plans of operation”. After the
accident, however, Gage was “impatient of restraint or advice when it conflicts with
hisdesires, attimespertinaciouslyobstinate,yetcapriciousandvacillating,devisingmany
plansoffutureoperations,which arenosoonerarrangedthanthey areabandonedinturn
forothersappearingmorefeasible”.Itwas asthoughanimportantcomponentofGage’s
abilitytoplanaheadrationally hadbeenremovedalongwithpartofhisbrain.
4Asinterestingasthesehintstothebrain’sfunctionweretomedicalresearchers,theymade
verylittleimpactonthefieldofeconomics. EvenJohnMaynardKeynes,withhisinterest
inmedicalpsychologyandpsychiatry,couldonlyinvoke“animalspirits”asacharacteristic of
human nature in 1936: “a spontaneous urge to action rather than inaction, and not as the
outcome of a weighted average of quantitative benefits multiplied by quantitative
probabilities”.5WhileKeynes’sanimalspiritsareanevocativemetaphoragainsttheconcept
ofHomo economicus—rationaleconomic man—they sound fartooshaman-like to bevery
satisfyingasanexplanationforhumanbehaviortoday.
At the same time that neuroscience was developing a more detailed understanding of
how the brain works, economic theory was becoming more narrowly focused on models of
perfectly rational behavior, so much so that despite the intellectual merits of alternatives
suchasHerbertSimon’s“satisficing”theoryofboundedrationality,themoremathematically
sophisticated rational expectations school of thought pioneered by John Muth (1961) and
RobertLucas(1972)quicklybecamethedominantperspectiveoftheeconomicsprofession
inthe1960sand1970s. Themoreempirical,foundationalapproachofneurosciencehadlittle
appealinthatclimate,anddespitethesubsequentexplosionofresultsinthebrainsciences,
thetwofieldswouldhavelittletosaytoeachotheruntilthe1990s.
3Harlow(1868,1974).
4Keynes(1936;1960,p.161).
5Keynes
himself took the term from the Scottish Enlightenment philosopher David Hume’s Enquiry
ConcerningHumanUnderstanding.
6
3 Fear
6Several
years ago, Robert Thompson, an airline pilot, stopped at a convenience store to
pick up a few magazines, but he turned around and walked right out of the store that he just
entered because he felt afraid, even though at the time he couldn’t understand why.
It turned out the store was being robbed at gunpoint, and shortly after Thompson left, a
police officer entered the store and was shot and killed. Only afterwards—with some
thoughtful debriefing by Gavin de Becker, a public safety expert—did Thompson realize
some of the things that may have triggered his discomfort: a customer wearing a heavy
jacketdespitethehotweather,theclerk’sintensefocusonthatcustomer, andasinglecar with the
engine running in the parking lot. But Thompson’s decision to leave the store
camealmostinstantaneously,longbeforehewasevenawarethathehadobservedanything
unusual.
Fearoftheunknown—FDR’s“nameless,unreasoning,unjustifiedterror”—isoneofthe
mostpowerful motivatingforces ofourconscious andsubconscious minds. Neuroscientists
havedemonstratedwithremarkabledetailthatourfearcircuitryishighlyrefined,insome
casesreactingmuchfasterthanwecanperceive. The“fightorflight”response, hardwired in all
mammals, is just one example of the wonderful evolutionary mechanisms that have
keptourspecies aliveforthepast100,000years. Butphysical threatsarenotthesameas financial
threats, and while high blood pressure, dilated blood vessels in our muscles, and a rush of
adrenaline may protect us from the former, they do little to shield us from the latter.
Infact,sustainedemotionalstresshasbeenshowntoimpairrationaldecision-making
abilities,leadingtosomewell-knownbehavioralbiasessuchas“doublingdown”ratherthan
cuttinglosses, selling atthebottomandbuying backatthetop,andotherfinancialtraps
thathaveconfoundedmostretailinvestorsandnotafewprofessionaltraders.
7Todevelopadeeperunderstandingofhowfearworks,wehavetolookinsidethehuman
brain,
perhaps the most complicated structure known to science. Most estimates put the
numberofneuronsinthebrainataroundonehundredbillion,notcountingthemanyother important
cell types found there.Each neuron can have several thousand synapses send6SeedeBecker(1997,p.27–28).
7See
Williams and Herrup (1988). Of course, this is only an “order of magnitude” estimate: the total
numberhasneverbeenphysicallycounted.
7
ingsignalstoothercells, forminganincredibly dense network ofinterconnections between
neurons. Incomparison, thenumber ofhuman beings thathave ever lived is estimated to be
substantially less than one hundred billion. If the average person throughout history only
made afew hundred personal connections in his orher lifetime (asseems likely), the
extended social network of everyone who has ever lived is still much less complex than a
singlehumanbrain.
The brain is not only complicated, but also extremely difficult to examine while
functioning. It is, in effect, what the mathematician Norbert Wiener called a “black box”, by
which he meant not an airplane’s flight-data recorder (those are brightly colored orange,
incidentally),butanopaquesystemwhereonecanonlyexaminetheinputsandtheoutputs.
Formanyyears,informationonhowtheblackboxfunctionedinternallywasscarce. Brain
researcherscouldonlyrelyonevidencefrompost-mortemneuroanatomy,casestudiesafter brain
surgery or other head injuries like Phineas Gage, and rather distressing “ablation”
experiments—in whichregionsofthebrainareselectively destroyed surgicallytosee what
theimpactis—performedonrats,monkeys,andothercreatures,undertheassumptionthat
brainfunctionsaresimilarinevolutionarilyrelatedspecies.
8Onesuchexperimenttookplacein1937,theyearafterKeynesmadehispronouncement
about“animalspirits”. Tworesearchers, theGerman´emigr´epsychologist Heinrich Kl¨uver
andtheAmericanneurosurgeonPaulBucy,wereattemptingtodiscoverwhichareasofthe brain
were involved in the visual hallucinations caused by mescaline, the active chemical
compoundinpeyotecactus. Inonesetofexperiments,Bucyremovedthetemporallobesof the
lateralcerebral cortex ofrhesus monkeys (inhumans, this part ofthe brain is slightly
aboveandbehindtheears). Kl¨uverandBucydiscoveredsomethingstartling: themonkeys’ ability
to see was not impaired, but their ability to recognize objects was. “The hungry
animal,ifconfrontedwithavarietyofobjects,will,forexample,indiscriminatelypickupa
comb,aBakeliteknob,asunflowerseed,ascrew,astick,apieceofapple,alivesnake,apiece
ofbanana,andaliverat. Eachobjectistransferredtothemouthandthendiscardedifnot edible”.
Atthesametime,themonkeysalsolosttheirsenseoffear,behavingcalmlyinthe
presenceofhumansandsnakes. Kl¨uverandBucycalledthisbehavior“psychicblindness”.
Themonkeysapparentlysufferednolossofvisualacuity,butwhattheysawhadlosttheset
8Kl¨uverandBucy(1937).
8
Kl¨uver-Bucysyndromewaslaterfoundinhumans,althoughitisveryrare.
ofemotionalandphysicalassociationstheypreviouslyconveyed.
Thiswasaremarkableresult—aparticularpartofthebrainwasresponsibleformediating
theemotionalresponsetorecognizinganobject. Weliveinaworldwhereimagerecognition
bycomputersisbecomingmorecommonbytheday,andwetendtothinkofitasanunemotional,purel
yrationalact. Itwouldbedisconcerting,tosaytheleast,ifwediscoveredthat
thesoftwareprocessingphotographsoflicenseplatenumbersinspeedtrapshademotion-like
responsesbasedonthenumbersitrecognized—butthat’sexactlywhatoccursinthebrain!
Infact,thebrainappearstohaveseveralpathwaysthatmediateemotion. Kl¨uverandBucy had
fortuitously removed the part of the brain essential for linking memories to fear: the
amygdala.
Theamygdalaisasmallbutdistinctstructurelocateddeepwithinthebrain. Inhumans, it is
located roughly where a line entering one’s eye and a line entering one’s ear would
intersect. Like most brain structures, the amygdala is paired. Early anatomists thought
itresembled an almond, hence its name, amygdala (the Latinized formofthe Greek word
for“almond”). ResearchersfollowinginKl¨uverandBucy’sfootstepssuspectedthatitwas
involvedinhowthebrainlearnedfear. Itwasnotuntilthelate1970s,however,whenthefirst
neurophysiological studies used the technique offearconditioning toexamine thefunction
oftheamygdala.
Even though it’s over a century old, many people know the story of Pavlov and his dogs:
theRussianscientistwouldringabellwhilefeedinghisdogs,andthedogsbecameso
conditionedtothesoundofthebellthattheywouldstillsalivatewhenPavlovranghisbell,
eveniftheyweren’tfed. Fearconditioninginvolvesreplacingtheunconditionedstimulus—in
Pavlov’sexperiments,food—withanegativestimulussuchasanelectricshock. Conditioned
fearlearningismuchfasterthanotherformsoflearning. Itcantakeplaceeveninasingle
sessionoflinkedstimuli,andcomparedtootherformsoflearning,itisnearlyindelible. There
aresoundevolutionaryreasonsforthisasymmetry, andthesamekindoffearconditioning
hasbeenfoundthroughouttheanimalkingdom,notmerelyinmammals.
9In1979,BruceKappandhisteamattheUniversityofVermontfirstpublishedevidence
thatlesionsonthecentralnucleusoftheamygdaladisruptedfearconditioninginrabbits.
Inspired bythiswork, JosephLeDoux(thenatCornellUniversity MedicalCollegeinNew
9Kapp(1979).
9
10YorkCity;nowatNewYorkUniversity’sCenterforNeuralScience),setouttotraceexactly
how a
fear-conditioned stimulus was processed by the brain. In his book The Emotional Brain,
LeDoux recounts how he discovered that pathway, or as he puts it, “the road map
offear“.LeDoux made lesions in thebrains ofrats conditioned to fearaspecific sound,
workingbackwardsalongtheknownpathwaysforauditoryprocessing. LeDouxwrites,“My
approachwastoletthenaturalflowofinformationbemyguide...Ireasonedthatdamaging
theearwouldbeuninteresting,sinceadeafanimalisobviouslynotgoingtobeabletolearn
anythingaboutasound. So,instead,Istartedbydamagingthehighestpartsoftheauditory
pathway”. It turned out that damaging the higher auditory functions in the cortex—the ‘rind’
of the brain—had no effect on fear conditioning. Damaging the auditory thalamus
furtherindid. ThisposedapuzzleforLeDoux: wheredidtheroadmapoffearlead,ifnot
alongthestandardauditorypathway?
Tofindtheanswer,LeDouxinjectedaspecialchemicaltracerintotheauditorythalamus.
Theneuronsthereabsorbedthetracerandsentthechemicaldownthelongthinconnections
oftheaxonstothenextstageofthepathway. Thebrainswerethensectionedandstainedto
determinewherethetracerendedup: “Brightorangeparticlesformedstreamsandspeckles
against a dark-blue background. It was like looking into a strange world of inner space”.
LeDouxfoundfourregionsthatcontainedthetracer. Threeofthoseregions,whendamaged,
showed no change in response in fear conditioning. The fourth region was the amygdala.
Theamygdala,itturnedout,wasthefinaldestinationoftheroadmapoffear.
Thereareseveral importantimplicationsofLeDoux’sresearchforfinancialcrises. Fear is the
hardwired fire alarm of the brain, setting off sprinkler systems and calling the fire department
automatically, sometimes even faster than we know. In his book, The Gift of
Fear,publicsafetyexpertGavindeBeckerpointsoutthatwecandetectandprocesssubtle cues of
impending danger far faster than our conscious minds realize. For example, when the hairs
on the back of your neck stand up, that’s your fear instinct kicking in, and you should pay
attention to it. The amygdala has direct connections to the brainstem, the central
switchboard for all the muscles in our body, and this neural shortcut from fear to
physicalmovementiswhatallowsusto(sometimes)duckapunchbeforewe’reevenaware
thatsomeoneistryingtohitus,andwhatcaused RobertThompsontomakeaquick exit
10LeDoux(1996).
10
even beforeheunderstoodwhy. Naturally,these automaticbehaviorsareextremely useful
forsurvival,particularlyinthefaceofphysicalthreats.
But when taken out ofits proper context, ourfear circuitry can becounterproductive,
andinsomecases,downrightdeadly. ThenaturalinstinctsthatsavedRobertThompson’s
lifeinthatconveniencestorewouldprobablyhavekilledhimlongagointhecontextofflying
anairplane, ifitweren’t forhis trainingasacommercial pilot. Pilotsrequire hundreds of
hoursoftrainingdesignedtoovercomeournaturalinstinctsashumanbeings. Forexample,
anall-too-commonmistake amonginexperienced pilots isthetendency topullback onan
airplane’scontrolwheeltopreventtheplanefromcrashingduringastall. Pullingbackon
thewheelcausestheairplanetopointupwards,andinthefaceofalife-threateningsituation,
it’snosurprisethatourinstinctivereactionistodirecttheplanetowardtheskyandaway
fromtheground.
11Unfortunately,inthiscontextourinstinctisexactlywrong—pointingtheplaneupwards
reducesitsairspeed,makingastallallbutcertainandsealingthepilot’sfate. Thecorrect
butcounterintuitivebehavioristopushthecontrolwheelforward,pointingtheplanedown— towards
the ground and a loss of altitude—which has the effect of increasing the plane’s
airspeed,decreasingthe“angleofattack”whichincreaseslifttoitswings,andallowingthe
pilottorecoverfromthestall,afterwhichhecanregainaltitude.Ofcourse,thismaneuver
involveslosingaltitudefirst,sothepilothastomakesurethattheangleandspeedofdescent
isn’ttoosteep;otherwisehe’llhitthegroundbeforegeneratingenoughlifttopulloutofthe dive.
Thisbalancingactisplayedoutinamatterofseconds,whichiswhysomanyhours
oftrainingisneededbeforeapilotbecomesapilot.
Thesamelogicappliestofinancialinvestments, riskmanagement,economicpolicyand
regulation,andcrisisresponse. Ineachofthesecontexts,fearcanplayaproductiveroleif
properlybalancedagainstotherconsiderations. Thefearoflosingmoneywillrationallycause
investorstomanagetheirrisksactivelyandinproportiontotheirexpectedreward;extreme fear,
however, can cause investors to quickly sell all their risky assets at fire-sale prices in
11One
of the industry’s standard textbooks, Jeppesen’s Guided Flight Discovery: Private Pilot (Willits, 2007,p.
3–38),lists three key steps to recoverfrom a stall, of which the first is this: “Decreasethe angle ofattack.
Depending onthe typeofaircraft,youmayfindthatadifferentamountofforwardpressureon
thecontrolwheelisrequired. Toolittleforwardmovementmaynotbeenoughtoregainlift;toomuchmay
imposeanegativeloadonthewing,hinderingrecovery”.
11
favorofgovernmentbondsandcash,whichmaynotservetheirlonger-termobjectivesifthey
maintaintheseholdingsfortoolong. Onabroaderscale,ifweallowourfearinstinctstodrive
ourreactiontofinancialcrises,wemayeventually regretthepolicyresponsesproducedby
ouramygdalas. Thisappliesnotonlytoinvestors,butalsotoregulatorsandpolicymakers,
whoseresponsetofearmayhaveconsiderablylargerconsequences.
TheworkofKapp,LeDoux,andmanyothersshowedthatthepathwayforfearresponse in the
brain sidesteps the higher brain functions, including the ones we usually associate
withrationality. Thispathwayleadsinsteadtoaspecificcenterthatprocessestheemotional
significanceofstimuli. Wefearthingsforreasonsoutsideourconscious,rationalmind,and we do
this because we have no choice; we are physiologically hardwired to do so. More broadly,
we behave, think, reach conclusions, and make decisions with the effects of the
emotionalbrainalwaysrunninginthebackground. Thishasclearimplicationsforeconomic
behavior,aswehaveseenoverthepastseveralyears.
4 Greed
Neurosciencehasshownthatfearanditsemotionalresponseareintimatelylinkedtodecisionmakin
ginthehumanbrain. Butwhataboutthemorepositiveemotions,suchashappiness, joy, asense
ofaccomplishment, orpleasure? Surely most economic decisions are madefor non-averse
reasons: after all, William Stanley Jevons spoke of a “double coincidence of wants”,
nota“double coincidence offears”. Itturns outthatneuroscience has something
tosayaboutthepleasurableemotionsaswell.
12In1954,tworesearchersatMontreal’sMcGillUniversity,JamesOldsandPeterMilner,
implanted
electrodes into the septal area of the brains of rats. These rats were placed in Skinner
boxes with a lever which, when pressed, would deliver a low voltage of 60-cycle alternating
current to the rat’s brain. These rats then did something remarkable: they wouldchoose
tohavetheirbrainselectricallystimulatedbyrepeatedlypressingthelever— on oneoccasion,
almost two thousand times a hour! Olds andMilner were careful torule
outthatthevoltagewasreducingthepainofimplantationinstead(understandablyso).
This strongly suggested to neuroscientists that there was a “pleasure center” in the
12OldsandMilner(1954).
12
brain. In fact, many electrode studies were performed across a variety of animals to find
thepleasure center, including several (ofdubious ethics) onhumans. As withmostthings
involving the brain, however, it was more complicated than it first appeared. Instead of a
pleasure center, the brain seems to have a reward system. The term “reward” may be a little
confusing to the reader with an economics background; in psychology, a “reward” is
anything positive which makes a behavior more likely. Rewards can be as basic and
fundamentalasfood,orasabstractandintangibleasintellectualsatisfaction. Surprisingly,
allthesedifferentrewards—food,sex,love,money,music,beauty—appeartousethesame
neurologicalsystem. Moreover,thepathwaysofthissystemalltransmitthesamechemical signal:
dopamine.
13Dopamineisacomparativelysimplecompoundthatwasoncethoughttohaveverylittle
neurologicalsignificance. Itwasbestknownasaprecursortoadrenalineinthebodyuntilin
1957theSwedishresearcherArvidCarlssonshowedthatitwasinfactaneurotransmitter,a
discoveryforwhichhewontheNobelPrizeforPhysiologyorMedicinein2000.14Carlsson
hadgivenreserpine,adrugknowntodepleteneurotransmitters,torabbits,whichthenfell
intoacatatonicstate. Carlssontheorizedthattherabbits’catatoniawascausedbyalackof
anas-yet-undiscoveredneurotransmitter. ByinjectingtherabbitswithL-DOPA,achemical
whichwouldbeconvertedtodopamineinthebrain,Carlssonwasabletorevivetherabbits—
leadingtheGreek-AmericanneurologistGeorgeCotziasonlyafewyearslatertosuccessfully
treatpatientswithParkinson’sdisease,andtheneurologistOliverSackstotreatparalyzed
patientswithsleepingsickness,ascelebratedinhisfamousbookAwakenings.
OnepeculiarityofpatientstreatedwithL-DOPAwasthattheyoftenbecameaddictedto
gambling. Thiswasoneofthefirstcluesthatdopaminewasinvolvedinthebrain’sreward system.
Other researchers discovered that addictive drugs such as cocaine and methamphetamine
flooded the brain with dopamine through the mesolimbic pathway, releasing it
intothenucleus accumbens, which islocatednotveryfarfromtheseptalareawhereOlds
andMilnerhadimplantedtheirelectrodes.
Neuroanatomistshavenowdiscoveredeightseparatedopaminepathwaysinthebrain,includingon
esassociatedwithattentionandlearning. While the full picture of how dopamine and the
reward system interact is still far from
13Carlssonetal.(1957).
14Sacks(1974).
13
15clear,
there is growing consensus among neuroscientists that the broad outlines have
been established.Theimplicationsforfinancialcrisis isclear: animbalance inanindividual’s
dopaminesystem caneasilyleadtogreaterrisk-taking,andifrisk-takingactivitiesare,on
average,associatedwithfinancialgain,apotentiallydestructivepositive-feedbackloopcan
easilyemergefromaperiodofluckydraws.
16Inanotherfascinatingstudyofthebrain’srewardsystem,ateamledbyHansBreiterat
HarvardMedicalSchoolandMassachusettsGeneralHospital,andincludingtheparticipation
ofpsychologistDanielKahneman,usedatechniqueknownas“functionalmagneticresonance
imaging”(fMRI)todetermine which areasofthebrainwere activatedwhenanindividual
experiencedmonetarygainsandlosses.Thisexperimentaldesigninvolvesplacingasubject in an
MRI machine (a long horizontal tube surrounded by a powerful magnet), attaching
amirrorata45-degreeangletotheceilingofthetube(sothesubjectcanseeacomputer
screenplacedjustoutsidethetube),askingthesubjecttoengageinavarietyofcomputergeneratedt
asksrequiringonlysimplemouse-clicks(whichsubjectscandosincetheirhands
arefree),andimagingtheirbrainsallthewhile.
WhatdoesfMRIactuallymeasure? Thisisanimportantquestioninallimagingstudies, and
indeed in all physiological studies of the human brain. The common denominator for
allsuchstudiesistofindphysical“correlates”tointernalmentalprocesseswithintheblack
boxofthebrain—minute physiological changes thatcorrelate tosubjective experience. In
themostcommonlyusedformoffMRI—blood-oxygenation-level-dependent contrastfMRI
(BOLD fMRI)—the oxygenation levels of the blood throughout the brain are measurable
becausehemoglobinmoleculeswithoutoxygenrespondmorestronglytoamagneticfieldthan
thosewithoxygen. Neuroscientistsreasonthatinanactiveregionofthebrain,theneurons will use
more oxygen than average, implying that the level of deoxygenated hemoglobin in that area
will increase relative to other areas. In deactivated regions of the brain, in
comparison,theneuronswilluselessoxygenthanaverage. Inthisway,fMRIdatacanshow
whichregionsofthebrainbecomemoreactive(orlessactive)inresponsetoagiventask.
In Breiter’s study, subjects were given a $50 stake (in real money, unlike other fMRI
15It
is tempting to speculate that because of the multiplicity of uses and pathways of dopamine in the brain, we
have many ways to feel pleasure, while we only have only one way to feel fear. There is some
supportforthisasymmetryfrompurelyevolutionarygrounds.
16Breiteretal.(2001).
14
17experiments),
and while in the fMRI machine, they were asked to play a simple gambling
game. On the computer screen that was projected into the tube in which they lay, one
ofthreecomputer-animatedspinners wasdisplayed, similartothekindfoundinchildren’s board
games. Each spinner was divided equally into three possible outcomes: the ‘good’
spinnerwith$10,$2.50,and$0;the‘intermediate’spinnerwith$2.50,$0,and-$1.50;and
the‘bad’spinnerwith$0,-$1.50,and-$6.Thearrowonthespinnerwastimedtotake
sixsecondstoreachitsfinaldestination,longenoughforthefMRItoimagethe“prospect” phase in
the subject. Once the spinner stopped, the arrow flashed for six more seconds,
longenoughforthefMRItoimagethe“outcome”phase. Unknowntothetestsubjects,the
outcomesofthespinnersonlyappearedtoberandom. Infact,thespinnerswentthrougha
preprogrammedsequencesuchthateachsubjectearned$78.50bytheendoftheexperiment.
What did Breiter, Kahneman, and their colleagues find? As the monetary rewards
increased, so did the activation in: the nucleus accumbens, part of the reward system; the
sublenticular extended amygdala,associatedwithemotionalreaction; thehypothalamus, a
partofthebraincloselylinkedtotheendocrinehormonalsystem;andtheventraltegmental area,
which releases dopamine into the reward system. This was a direct neurological
correlatetomonetaryreward.
Evenmoreintriguing,thepatternofactivationsinthemonetaryrewardprocesslooked
extremely familiar to Breiter. In fact, it was the same pattern he had found a few years
beforeinanotherstudyheconductedwithcocaineaddictsandfirst-timemorphineusers! In
thehumanbrain, monetarygainstimulates thesame rewardcircuitry ascocaine—inboth
cases,dopamineisreleasedintothenucleusaccumbens,reinforcingthebehavior. Inthecase
ofcocaine,wecallthisaddiction. Inthecaseofmonetarygain,wecallthiscapitalism. In other
words, our most fundamental reactions to monetary gain are hardwired into human
physiology.
NeuroscientistshavealsoattemptedtolinktheresultsoffMRIresearchdirectlytoeconomictheor
y. Forexample,ReadMontagueatBaylorMedicalCenterandGregoryBernsat EmoryUniversity
SchoolofMedicine have triedtodiscover howthebrain’sdifferentreac17As
the experimenters note, “The gains were made larger than the losses to compensate for the
wellestablished tendency of subjects to assign greater weight to a loss than to a gain of equal magnitude”, a
psychologicalresultwhichcomesdirectlyfromKahnemanandTversky’sresearch.
15
Theysuspectthatthe
brainusesacommonscaleofvaluationtocomparedifferentoutcomes. Intheirview,dueto
thevastmultiplicityofpossiblehumanbehaviors,thebrainneedsasingleinternalscaleof
representingvaluetochooseapropercourseofaction—althoughthiscourseofactionmight
notberationalfromthestandpointofHomoeconomicus!
18tionstofinancialrewardtranslateintoaninternalmental“currency”.
19Other
researchers have tried touse fMRI research topredict economic behavior. Since
many brain regions are activated before a specific type of behavior—e.g., the nucleus
accumbensandrisk-seeking—BrianKnutsonandPeterBossaertsatStanfordUniversityhave
theorizedtheseanticipationscouldbeusedtocreatea“physiologicallyconstrained”theory
ofdecision-making.ThisissomewhatreminiscentofHerbertSimon’sattempttoemulate
thepsychology ofthehuman decision-making process inacomputer program. Here,
however,theneurologicalcorrelatescouldbedirectlymeasuredbyfMRIandotherbrainimaging
techniques,andtheresultingbehaviorscomparedagainsttheresultsofthetheoreticalmodel.
20Ofcourse,thefMRImethodhasitslimitations.
Itsspatialresolution,whichcandetect volumes the
size of a grain of sand or the head ofa pin, is much toocoarse to detect the
activityofasingleneuron,orevenofasmallgroupofneurons. Itsresolutionintimeiseven
coarser,takingseveralsecondstobuildupasingleimage.Someresearchersareskeptical of the
chain of logic which links deoxygenated blood to local brain activity; at best, they argue, it is
imperfectly correlated. Moreover, even under the most favorable conditions,
fMRIonlyprovidestheresearcherwithbrain-activitydata. Itisalittleasthoughsomeone were
attempting to study how New York City worked, but the only information they had
aboutthecitywasthepowercompany’smeterreadingsblockbycityblock. Itwouldtake
atrulyskilledresearchertodiscoverthepurposeoftheFinancialDistrictorBroadwayfrom that data,
and events as memorable as the Thanksgiving Day parade would effectively be
invisibletotheresearcher.
Nevertheless,fMRIhasbeenrevolutionaryinallowingresearcherstoseeinsidethe“black
box”ofthebrainastheynevercouldbefore.
Entirelynewareasofresearchlinkingneurosciencetoeconomicsandfinancehaveemergedthanks
totheuseoffMRI,andwehavebarely
18MontagueandBerns(2002).
19KnutsonandBossaerts(2007).
comparison, the old-fashioned electroencephalograph could record changes in the brain’s surface
electricalactivityinmilliseconds.
20In
16
scratchedthesurfaceofpotentialinsightsfromthistool. Inparticular,wehaven’ttouched
onhigherbrainfunctionssuch aslogicalreasoning,numerical computation, andlong-term
planning,allintimatelyinvolvedintheeconomicandfinancialdecision-makingprocess. Nor have
we faced the thorny questions of intelligence and consciousness, about which we are
stillinastateofdeepignorance,evenifourknowledgeisgrowingexponentiallyeachday.
5 Risk
21If
our reactions to monetary gain are hardwired, what about our reactions to monetary
risk? Aversiontoriskseemsnearlyuniversalamongalllivingorganisms,mostlikelyaclose
corollaryofthesurvivalinstinct. Infact,inasimpleevolutionarymodelofbehavior,Thomas
BrennanandIhave shown thatwhen therearesystematic environmental risks tofertility,
theforcesofnaturalselectionwillfavorthoseindividualsthatareriskaverse!22Thereason issimple:
ifonecourseofactionleadstothreeoffspringwithcertainty,andasecondcourse of action leads to
a 50/50 gamble of two or four offspring, it can be shown that the first
courseofactionleadstomuchfasterpopulationgrowth.
23Buthumanresponsestoriskaremoresubtlethansimpleriskaversionsuggestions.
One
strikingexampleisthe“Peltzmaneffect”,namedaftertheUniversityofChicagoeconomist
SamPeltzmanwho,in1975,publishedacontroversialstudyshowingthatgovernmentregulationsr
equiringtheuseofautomobilesafetydevicessuchasseatbeltsdidlittletoreduce
thenumberofhighwaydeathsbecausepeopleadjustedtheirbehavioraccordingly,presumablydriv
ingfasterandmorerecklessly.Infact, someofhisdatashowed thatovertime, while the number of
fatalities among auto occupants did decline, this benefit was almost
entirelyoffsetbyanincreaseinthenumberofpedestriandeathsandnonfatalaccidents. He
concluded thatthebenefits ofsafetyregulationswere mostlynegatedbychanges indriver
behavior. Sincethen,manystudieshaveextendedPeltzman’soriginalstudybyconsidering
additionalsafetydevicessuchasairbags,anti-lockbrakes,crumplezones,etc. Insomecases
thesenewstudieshaveconfirmed,andinothercasesthey’verefutedPeltzman’sfindingsaf21BrennanandLo(2011).
22ThisisaconsequenceofJensen’sInequality,which,inthissimpleexample,isillustratedbythefactthat
thesafechoiceyields3×3=9individualsaftertwogenerationswhereastheriskychoiceyields2×4=8 onaverage.
SeeBrennanandLo(2011)foramoreformalderivation.
23Peltzman(1975).
17
24tercontrollingforotherconfoundingfactorssuchasenforcementpractices,driverage,rural
vs.
urban roads, vehicle weight, and so on.These ambiguous results are not surprising
giventhemanydifferentcontextsinwhichwedriveautomobiles. Whileitseemsreasonable
thataharriedcommuterwouldcertainlytakeadvantageofimprovedsafetybydrivingfaster and
gettingto work afew minutes earlier, the same probably doesn’t hold forvacationers
touringthecountryside.
25However,inthemostrecentstudyofthisgenre,twoeconomists,RussellSobelandTodd
Nesbit,
decided to turn their attention to the one driving venue where there are very few
confounding factors, and there’s no doubt thatalldrivers areintensely focused on getting
totheirfinaldestinationasquicklyaspossible—NASCARraces.Theirconclusion: “Our results
clearly support the existence of offsetting behavior in NASCAR—drivers do drive more
recklessly in response to the increased safety of their automobiles”. When the only
goalistoreducedrivingtime,itseemsperfectlyrationalthatincreasedsafetywouldinduce
driverstodrivefaster. Fromafinancialperspective,thisiscompletelyconsistentwithbasic
portfoliotheory: ifanasset’svolatilitydeclinesbutitsexpectedreturnremainsunchanged,
investors will put more money into such an asset, other things (like correlations to other
assets)equal.
Butwhatifsafetyimprovementsareperceived tobemoreeffectivethantheyare? Then drivers
mayenduptakingmoreriskthantheyintended to,simply because theyfeltsafer
thantheyreallywere. Riskperceptionmaydifferfromriskreality,andthiswasobviously a critical
factor in the recent financial crisis. Given the AAA ratings of CDOs and their
relativelyshorthistoryofgrowthandprofitability,certaininvestorsmayhavethoughtthey were
safer than, in fact, they were. This adaptive natureofhuman risk preferences is one
ofthemostimportantreasonsforproducingaccurateandtimelyriskanalyticsinfinancial contexts.
However,evenwhenriskisaccuratelymeasured,humanbehaviorshowssomeveryinteresting
biasesinhowlossesandgainsareweighed. Forexample,consideraslightlymodified version of
an experiment conducted by Daniel Kahneman and Amos Tversky in 1979 for
24See,forexample,CrandallandGraham(1984),Farmeretal.(1997),andCohenandEinav(2003).
25SobelandNesbit(2007).
18
which Kahneman was awarded the Nobel Prize in Economics in 2002. 26Suppose you’re
offered two investment opportunities, A and B: A yields a sure profit of $240,000, and B
isalotteryticket yielding $1millionwitha25%probability and$0with75%probability. If you had to
choose between A and B, which would you prefer? While investment B has
anexpectedvalueof$250,000whichishigherthanA’spayoff,youmaynotcareaboutthis fact
because you’ll receive either $1 million or zero, not the expected value. It seems like
there’snorightorwrongchoicehere;it’ssimplyamatterofpersonalpreference. Facedwith this
choice, most subjects prefer A, the sure profit, to B, despite the fact that B offers a
significantprobabilityofwinningconsiderablymore. Thisisanexampleofriskaversion.
Now suppose you’re faced with another two choices, C and D: C yields a sure loss of
$750,000,andDisalotteryticketyielding$0with25%probabilityandalossof$1million
with75%probability. Whichwouldyouprefer? Thissituationisnotasabsurdasitmight
seematfirstglance;manyfinancialdecisionsinvolvechoosingbetweenthelesseroftwoevils. In
this case, most subjects choose D,despite the fact that D is more risky than C. When faced
with two choices that both involve losses, individuals seem to behave in exactly the
oppositeway—they’reriskseekinginthiscase,notriskaverseasinthecaseofA-versus-B.
The factthatindividuals tendtoberiskaverse inthefaceofgainsandriskseeking in
thefaceoflosses—whichKahnemanandTversky(1979)called“aversiontosureloss”—can
leadtosomeverypoorfinancialdecisions. Toseewhy,observethatthecombinationofthe
mostpopularchoices,A-and-D,isequivalenttoasinglelotteryticketyielding$240,000with
25%probabilityand-$760,000with75%probability,whereasthecombinationoftheleast
popularchoices,B-and-C,isequivalenttoasinglelotteryticketyielding$250,000with25%
probabilityand-$750,000with75%probability. The B-and-Ccombinationhasthesame
probabilitiesofgainsandlosses,butthegainis$10,000higherandthelossis$10,000lower.
Inotherwords,B-and-CisidenticaltoA-and-Dplusasureprofitof$10,000. Inlightofthis
analysis,wouldyoustillpreferA-and-D?
Acommonresponsetothisexperimentisthatit’sunfairbecausethetwopairsofinvestmentoppor
tunitieswerepresentedsequentially,notsimultaneously. Butthefactisthatall
ofusareconstantlymakingdecisionsaboutriskychoicesoneaftertheother,andwedon’t
alwayshavetheluxuryofcontemplatingthecumulativeeffectsofthosedecisionsbeforewe
26Tverskydiedin1996,otherwisehewouldnodoubthavesharedtheprizewithKahneman.
19
makethem. In fact, aversion to sure loss is a very real problem thatlies at the heart of one of
the
biggestpotentialexposuresofeverymajorfinancialinstitution: theroguetrader. Thecases
ofNickLeeson(Barings,1995,£827millionloss),YasuoHamanaka(Sumitomo,1996,$2.6
billionloss),JohnRusnak(AlliedIrishBanks,2002,$691millionloss),ChenJiulin(China
AviationOil,2005,$550million),JeromeKerviel(Soci´et´eG´en´erale,2006–2008,e4.9billion
loss), Boris Picano-Nacci (Caisse d’Epargne, 2008, e751 million loss) and, most recently,
KwekuAdoboli(UBS,2011,$2.3billionloss)arealltoofamiliar: atraderlosesmorethan
heexpected,butratherthanowninguptothelossandmovingon,hehidesitandincreases
hisbet,hopingtomakeituponthenexttrade,afterwhichallmightbeforgiven. Ofcourse, this rarely
happens, and the “doubling down” process continues, usually until the losses become so
large as to be impossible to hide. No wonder the first piece of advice given to
novicetradersbymoreseasonedprofessionalsisto“cutyourlossesandrideyourgains”;in
otherwords,don’tbeoverlyaversetosurelosses!
27This
advice applies not only to traders and investors, but also regulators. While we still
have much to learn about the behavior of bank supervisors in the years leading up
totherecentfinancialcrisis,someeconomistsclaimthatregulatoryforbearance—thetacit or active
cooperationof regulators in overvaluing bank assets to avoid violating minimum
capitalrequirements—ispartlyresponsibleforthecrisis.28Althoughthereareelaborateexplanation
sforwhyregulatoryforbearancemightoccur,includingglobalcompetitionamong
regulatoryagenciesandthepoliticaleconomyofregulation,amoremundaneexplanation is
aversion to sure loss. When a bank supervisor first identifies an undercapitalized bank, he
must decide whether torequire thebank toraise additional capital, orto waitand see whether
the bank’s assets will rebound. Requiring a bank to raise capital is costly to the
supervisorintermsofthebank’sinvariablynegativeresponse,aswellasthepotentialrisk that this
action may cause a loss of confidence among the bank’s customer base, possibly triggering
abank run. Even worse, the regulatory action may, in retrospect, seem
unwarranted,causingalossofconfidenceintheregulator’scompetence.
Waitingtoseewhetherthe
bank’sassetswillincreaseinvalue—therebyeliminatingtheneedforsuchcostlyregulatory
27HuizingaandLaevan(2010),BrownandDinc(2011).
28Espinosa-Vega,Kahn,Matta,andSol´e(2011).
20
action—isaformof“doublingdown”,withsimilarconsequences.
Notsurprisingly,theasymmetrybetweenourreactionstomonetarygainsandlosseshas
29aneurophysiologicalexplanation.
CameliaM.KuhnenandBrianKnutsonatStanfordUniversityquicklyfollowedupBreiter’sexperime
ntswithanotherfMRIstudy.Experimental subjects played
acomputergameKuhnenandKnutsondeveloped—the
BehavioralInvestmentAllocationStrategy(BIAS)task—whilebeingscannedintheMRI.Theplayer
shada choicebetweenthreeinvestment options,a“safe”bondoroneoftwostocks, whichmoved
randomly. Unknowntotheplayers, oneofthestockswasa“good”stock, whichgainedin the long
run, and the other, a “bad” stock, which declined in the long run. Additionally,
the“good”stockgavealargerlong-runrewardthanthe“safe”bond,onaverage$2.50per
turnversusaconsistent$1.
30KuhnenandKnutsondiscovered
averyinterestingpattern. Whenplayersmadeariskseeking
mistake—e.g., choosing the “bad” stock over the “good” stock—their nucleus
accumbenswasactivatedbeforetheymadetheirdecision. Recallthatthenucleusaccumbens
isthesamepartoftherewardcircuitthatisactivatedinresponsetococaineandmonetary gain.
Incontrast,beforeplayersmadearisk-aversemistake—e.g.,choosingthe“safe”bond
overthe“good”stock—acompletelydifferentpartofthebrainwasactivated,theanterior insula.
Thispartofthebrainisnotassociatedwithanyrewardpathwaysatall;rather,it
seemstobeassociatedwithdisgust,whetherduetoanunpleasantodor,expressionsofsomeone
reacting to an unpleasant odor, or seeing graphic pictures of contamination or bodily
mutilation.Itseemsrisk-averseinvestorsprocesstheriskofmonetarylossalongthesame
circuittheycontemplateviscerallydisgustingthings,whilerisk-seekinginvestorsprocessthe
riskypotentialgainalongthesamerewardcircuitsascocaine.
6 Rationality
Inthemid-1970s,asuccessful35-year-oldbusinessmanbegansufferingfromintenseheadaches
and a lack of concentration, enough to disrupt his personal and professional life. He was
diagnosedwithabraintumor,ameningiomathesizeofasmallorange,whichwaspressing
athisfrontallobesfrombelow. Hissurgerytoremove thetumorwassuccessful, although
29KuhnenandKnutson(2005).
30Wickeretal.(2003),Wrightetal.(2004).
21
31some
frontal lobe tissue was removed as well. His intelligence, his motor skills, his ability
touselanguagewereundamagedinhisrecovery,buthispersonalitywasdrasticallyaltered.
Helostallsenseofproportionathisplaceofemployment,spendingthedayobsessingover
unimportantdetailswhileignoringthemostpressingtasks. Decidingwhatclothestowear in the
morning or what restaurant to dine in at night consumed an inordinate amount of time. He
soonlosthisjob, quickly runningthroughaseries ofbadbusiness ventures, and
thenhiswifelefthim. Heremarriedandthenquicklydivorced. Bythetimetheneurologist Antonio
Damasio encountered him, this man was attempting to get his disability benefits
restored;theyhadbeencancelledsincehismentalandphysicalabilitieswere,intheopinion
ofotherdoctors,stillintact. Themanwas,toallexternalappearances,a“malingerer”.
Damasiowasdoubtful. Thenewimagingtechniques
ofthetime—computerizedtomography(CT),magneticresonanceimaging(MRI),andsingle-photo
nemission computedtomography (SPECT)—were used to scan the patient’s brain. They
revealed very localized lesions on the left and right frontallobes ofhis cortex. The man—the
neurological literaturereferstohimas“patientE.V.R.”,butDamasioinhisbookDescartes’Error
giveshim thepseudonym“Elliot”—onlyhadasmallportionofhisbraindamaged,theventromedial
prefrontalcortex, locatedafewcentimeters behindthelower forehead. Damasiotheorized
thatthissmallsectionofthebrainwasinvolvedinthehigherfunctionofdecision-making.
32However,
unlike otherpatients with frontal-lobedamage, Elliotperformed normallyon
specialized psychological and personality tests. After extensive conversations with him,
however, Damasiobegantobelieve there was something else missing besides hisability to
makegooddecisions. Althoughapleasant,evenwittyconversationalist,Elliotshowedvery
littleemotionalaffecttalkingabouthismisfortunes. AsDamasioprobedfurther,hefound
thatElliotwasalmostalwaysonaseeminglyevenemotionalkeel: neversad,neveranxious, never
impatient, and only very briefly angry. Psychological tests measuring physiological reactions
to violent imagery confirmed this deficit. Afterone series oftests, Elliot himself
confirmedthischangetoDamasio: “topicsthathadonceevokedastrongemotionnolonger
causedanyreaction,positiveornegative”. Damasiotentativelycalledthissetofconditions
“acquired sociopathy”.Apparently, this loss of emotional faculties had a surprisingly
31Damasio(1994,pp.34–37),EslingerandDamasio(1985).
32Damasio(1994,pp.41–45),SaverandDamasio(1991),Damasio,Tranel,andDamasio,(1991,1998).
22
profoundeffectonElliot’sday-to-dayactivities,asDamasio(1994,p.36)describes:
Whenthejobcalledforinterruptinganactivityandturningtoanother,hemight
persistnonetheless,seeminglylosingsightofhismaingoal. Orhemightinterrupt
theactivityhehadengaged,toturntosomethinghefoundmorecaptivatingat that
particular moment... The flow of work was stopped. One might say that
theparticularstepofthetaskatwhichElliotbalkedwasactuallybeingcarried
outtoowell,andattheexpenseoftheoverallpurpose. OnemightsaythatElliot
hadbecomeirrationalconcerningthelargerframeofbehavior....
Elliot’sinabilitytofeel—hislackofemotionalresponse—somehowcausedhimtomakeirrationalch
oicesinhisdailydecisions.
33This
conclusion surprises many economists because oftheassociationbetween emotion
andbehavioralbiases. Afterall,isn’titfearandgreed,or“animalspirits”asKeynesonce suggested,
that cause prices to deviate irrationally from “fundamentals”? In fact, a more sophisticated
view of the role of emotions in human cognition is that they are central to
rationality.Emotionsarethebasisforareward-and-punishmentsystemthatfacilitatesthe
selectionofadvantageousbehavior,providinganumeraireforanimalstoengageina“costbenefitan
alysis”ofthevariousactionsopentothem(Rolls,1999,Chapter10.3). Evenfear and greed—the
two most common culprits in the downfall of rational thinking, according
tomostbehavioralists—aretheproductofevolutionaryforces,adaptivetraitsthatincrease
theprobabilityofsurvival. Fromanevolutionaryperspective,emotionisapowerfultoolfor
improving the efficiency with which animals learn from their environment and their past.
When an individual’s ability to experience emotion is eliminated, an important feedback
loopisseveredandhisdecision-makingprocessisimpaired.
What,then,isthesourceofirrationality,ifnotemotion? Theneuroscience perspective provides
a hint, from which we can craft a conjecture. Neuroscientists have shown that
emotion—especiallyfearandthefight-or-flightresponse—isthe“firstresponse”inthesense
33See,
for example,Damasio (1994)andRolls (1990,1994,1999). Recent researchinthe cognitiveneurosciences
and economics suggest an important link between rationality in decision-making and emotion
(GrossbergandGutowski,1987;Damasio,1994;Elster,1998;Lo,1999;LoandRepin,2002;Loewenstein,
2000;andPetersandSlovic,2000),implyingthatthetwoarenotantithetical,butinfactcomplementary.
Forexample,contrarytothecommonbeliefthatemotionshavenoplaceinrationalfinancialdecision-making
processes,LoandRepin(2002)presentpreliminaryevidencethatphysiologicalvariablesassociatedwiththe
autonomicnervoussystemarehighlycorrelatedwithmarketeventsevenforhighlyexperiencedprofessional
securitiestraders. Theyarguethatemotionalresponsesareasignificantfactorinthe real-timeprocessing
offinancialrisks,andthatanimportantcomponentofaprofessionaltrader’sskillsliesinhisorherability
tochannelemotion,consciouslyorunconsciously,inspecificwaysduringcertainmarketconditions.
23
34that
we exhibit emotional reactions to objects and events far more quickly than we can
articulatewhatthoseobjectsandevents are,asinRobertThompson’s
case.Infact,extremeemotionalreactionscan“short-circuit”rationaldeliberationaltogether(seeBa
umeister, Heatherton, and Tice, 1994), i.e., strong stimulus to the amygdala seems to inhibit
activityintheprefrontalcortex,theregionofthebrainassociatedwithlogicaldeliberation
andreasoningability. Fromanevolutionarystandpoint,thisseemsquitesensible—emotional
reactionsareacall-to-armsthatshouldbeheededimmediatelybecausesurvivalmaydepend
onit,andhigherbrainfunctionssuchaslanguageandlogicalreasoningaresuppresseduntil
thethreatisover,i.e.,untiltheemotionalreactionsubsides.
35However,inourcurrentenvironment,many“threats”identifiedbytheamygdalaarenot,
infact,life-threatening,yetourphysiologicalreactionsmaystillbethesame. Insuchcases,
thesuppressionofourprefrontalcortexmaybeunnecessaryandpossiblycounterproductive,
whichisimplicitinthecommonadvicetorefrainfrommakinganysignificantdecisionsafter
experiencingthedeathofalovedone,orasimilaremotionaltrauma. Thisissageadvice,for
theabilityto“thinkstraight”isgenuinelyphysiologically hamperedbyextremeemotional reactions.
Thecomplexity oftheinteractionsamongthedistinctcomponentsofthebrainmaybe
illustratedbytwoexamples. Thefirstinvolvesthedifferencebetweenanaturalsmileanda
“forced”smile(seeDamasio,1994,pp.141–143andFigure7-3),whichiseasilydetectedby
mostofus, butwhy? The answer liesinthefactthatanaturalsmile isgeneratedby one
regionofthebrain—theanteriorcingulate—andinvolvescertaininvoluntaryfacialmuscles
thatarenotunderthecontrolofthemotorcortex. Theforcedsmile, however, isapurely voluntary
behavior emanating from the motorcortex, and does notlook exactly the same because
involuntary muscles donotparticipateinthisaction. Infact,ittakes greateffort
andskilltogenerateparticularfacialexpressionsoncue,asactorstrainedinthe“method” school
can attest—only by conjuring up emotionally charged experiences in their past are
theyabletoproducethekindofgenuine emotionalreactionsneeded inagivenscene, and
34SeeSection3,deBecker(1997),andZajonc(1980,1984).
35Otherfamiliarmanifestationsoftheantagonisticeffectofemotionontheprefrontalcortexincludebeing
soangrythatyoucannotsee(“blindedbyyouranger”,bothphysicallyandmetaphorically),andbecoming
tongue-tiedanddisorientedinthepresenceofsomeoneyoufindunusuallyattractive. Bothvisionandspeech
aremediatedbytheprefrontalcortex.
24
anythinglessauthenticisimmediatelyrecognizedas“badacting”.
ThesecondexampleisfromastudybyEisenberger,Lieberman,andWilliams(2003)in
which they deliberately induced feelings ofsocial rejection among agroup ofsubjects and
thenidentifiedtheregionsofthebrainthatweremostactivatedduringthestimulus. They discovered
thattwocomponents were involved, theanteriorcingulate andtheinsula, both
ofwhicharealsoknowntoprocessphysicalpain. Inotherwords,emotionaltrauma—hurt
feelings,emotionalloss,embarrassment, andshame—cangeneratethesamekindofneural
response that a broken bone does. Many who have experienced the death of a loved one
havecommentedthattheyfeltphysical painfromtheirlossdespitethefactthatnophysical trauma
was involved, and we are now beginning to develop a neuroscientific basis forthis
phenomenon. Eisenberger,Lieberman,andWilliams(2003,p.292)concludethat“...social
painisanalogousinitsneurocognitivefunctiontophysicalpain,alertinguswhenwehave
sustainedinjurytooursocialconnections,allowingrestorativemeasurestobetaken”.
These two examples illustratesomeofthemanyways inwhich specialized components in
the brain can interact toproduce behavior. The first example shows that two different
components of the brain are capable of producing the same outcome: a smile. The second
example shows that the same components can be involved in producing two different
outcomes: physicalandemotionalpain.
Thepointofspecializationinbrainfunctionisincreasedfitnessintheevolutionarysense.
Eachspecializedcomponentmaybeviewedasan
evolutionaryadaptationdesignedtoincreasethechancesofsurvivalinresponsetoaparticularenvir
onmentalcondition. Asenvironmentalconditionschange,sotoodoestherelative
importanceofeach component. Oneofthe unique features ofHomo sapiens is theability
toadapttonewsituationsbylearningandimplementingmoreadvantageousbehavior,and
thisisoftenaccomplishedbyseveralcomponentsofthebrainactingtogether. Asaresult, what
economists call “preferences” are often complicated interactions among the various
componentsofthebrain.
Thisperspectiveimpliesthatpreferencesmaynotbestablethroughtime,butarelikely
tobeshapedbyanumberoffactors,bothinternalandexternaltotheindividual,i.e.,factors related
tothe individual’s personality, andfactors related tospecific environmental
conditionsinwhichtheindividualiscurrentlysituated. Whenenvironmentalconditionsshift,we
shouldexpectbehaviortochangeinresponse,boththroughlearningand,overtime,through
25
changesinpreferencesviatheforcesofnaturalselection. Theseevolutionaryunderpinnings are
more than simple speculation in the context offinancial market participants. The
extraordinarydegree ofcompetitiveness ofglobalfinancialmarkets andtheoutsized rewards
thataccruetothe“fittest”traderssuggestthatDarwinianselectionisatworkindeterminingthetypical
profileofthesuccessfulinvestor. Afterall,unsuccessfulmarketparticipants
areeventuallyeliminatedfromthepopulationaftersufferingacertainleveloflosses.
36SinceDamasio’spathbreakingstudiesoftheroleofemotioninrationalandirrationalbehavior,sev
eralofDamasio’sstudentsandcolleaguesattheUniversityofIowahavedeveloped
newtestsforpatientswithsimilarneuropathologies.
AntoineBechara,thenDamasio’spostdoctoralstudent,devisedwhatisnowcalledtheIowaGambli
ngTask.Thispsychological
testtakessomeofitsinspirationfromDanielKahnemanandAmosTversky’sexperiments,
butBechara wanted touse asrealistic adecision-making task as possible, so heturned to
thatverycommonpastime,adeckofcards.
Inthebasictask,theexperimentaltestsubject—calledthe“player”—isseatedinfront
offourdecksofcardsandisgiven$2,000inrealistic-lookingplaymoney. Theobjectofthe game is
to lose as little money and gain as much money as possible. The player turns a
cardselectedfromanyoneofthedecks,andeitherwinsorlosesacertainamountofmoney
foreachturn. Whattheplayerdoesnotknowbeforehand,ofcourse, isthatthedecks are rigged.
DecksAandBpay$100foreachturnofacard,butdeckAwilloccasionallycost
theplayerafewhundreddollars—enoughsothatapurestrategyfromdeckAwilldeplete
theirstake—anddeckBwilllessfrequentlypenalizetheplayer$1,250dollars. DecksCand D, on
the other hand, pay $50 per turn, with deck C occasionally penalizing the player a small
amount, $25or$50or$75, and deck D infrequently penalizing the player $250, but
neverenoughtocausealossinthelongrun.
Regular players—that is, the control group—typically start offthe gameby trying out
cardsfromeachofthefourdecks. Then,luredbythepromiseofalargerpayoff,theyfocus
ondecksAandB,untiltheyrealizethisisnotawinningstrategy. Thistypicallyhappens within the
first thirty cards. The player then switches to decks C and D, although some risk-takers will
stilloccasionallysample cardsfromdecks AandBaswell. This continues
onforahundredcards,whichiswhenthecroupier/experimentercallsahalttothetest.
36Becharaetal.(1994).
26
37Players
with damage totheir ventromedial prefrontal cortex or their amygdala employ a
completely different strategy from the control group. They start off in the same way,
sampling the decks, but as the game continues they prefer decks A and B over decks C and
D, despite the fact that those decks are designed to bankrupt the player! When the player
inevitably goes bankrupt, the experimenter loans them more money. Even frontal patients
who describe themselves as “low-risk” will systematically choose decks A and B much more
often than regular players who describe themselves as “high-risk”.Without certain emotional
faculties, the ability to process risk is clearly impaired. This finding
suggeststhatemotionplaysacriticalroleinproducingrationaltrade-offsbetweenriskand
reward,whichisthecruxoffinancialdecision-making.
Whatweconsidertobe“rational”behavioris,infact,acomplexbalancingactbetween anumber
ofcomponents ofthebrain, some hardwired, others moreadaptive, andifthese
componentsbecomeimbalanced—eithertoomuchfearortoolittlegreed—weobserve“maladaptiv
e”behavior. Therefore,thedefinitionofrationality,anditsopposite,isinextricably
tiedtoanindividual’s environment. The greatwhite shark moves throughthewaterwith
fearsome grace and efficiency, thanks to 400 million years of natural selection—but take
thatsharkoutofwaterandontoasandybeach,anditsflailingundulationswillseemquite irrational!
The origins of human behavior are similar, differing only in the length of time
wehavehadtoadapttoourenvironment(about2millionyears),andthespeedwithwhich
thatenvironmentisnowchanging,thankstotechnologicaladvances.
EvolutionarilyadvantageousresponsesbyHomosapiens
tothreatsontheplainsoftheAfricansavannah50,000
yearsagomaynotbeaseffectiveindealingwiththreatsontheflooroftheNewYorkStock
Exchangetoday.
Therefore,weshouldn’tbesurprisedtofindthatthelackofsunlightduringwintermonths
tendstodepressstock-marketprices(Kamstra,Kramer,andLevi,2003),thattraderswho
exhibittoolittleortoomuchemotionalresponsetendtobelessprofitablethanthosewith mid-range
sensitivity (Lo and Repin, 2002; Lo, Repin, and Steenbarger, 2005), and that
traderstendtomakemoremoneyondayswhentheirlevelsoftestosteronearehigherthan average
(Coates and Herbert, 2008). These are just a few examples from the emerging
“neuroeconomics”literatureinwhicheconomicbehaviorisbeingreinterpretedfromaneu37Damasio(1994,pp.212–217).
27
rophysiologicalperspective,providingadeeperandricherbasisforunderstandingrationality
andirrationality.
7 Sentience
Whileneuroscience clearly shows thatthehumandecision-making process isvery farfrom the
hyper-rationality ofHomo economicus,the Efficient Markets Hypothesis suggests that
thismightnotmattervery much. Consideramodernfinancialmarketwithmanytraders.
Ifonetradermakesapoordecisionundertheheatofemotion,anothertraderactingmore
rationallyshould seethisasanarbitrageopportunityandmake aneasyprofit. Ofcourse,
weknowthatthisidealdepictionofthewisdomofcrowdsdoesnotalwayshappen—entire
marketscanbeinfectedwithwhatthenineteenth-centuryjournalistCharlesMackaycalled “the
madness ofcrowds”—but itdoes happen farmoreoften thannot. Butwhat ifthere
werebiologicallimitstohumanrationalityitself?
It’s a truism in freshman economics that price is determined by supply and demand,
buteacheconomictransactionhasabuyerandaseller,eachtryingtocometoamutually
satisfyingagreementviaJevons’saforementioned“doublecoincidenceofwants”. Ifaseller
refuses to lower the asking price to a level abuyer wishes to bid, no transaction will take
place. Thatmightbearationaldecision ontheseller’s part. Ontheotherhand,itmight
reflectalackofawarenessofwhatthebuyeriswillingtooffer. Awell-functioningmarket’s
price-discoveryprocessrequiresparticipantstoengageinacertaindegreeofcause-and-effect
reasoning: “If I do this, then others will do that, which means I should...”. This chain of logic
presumes that individuals have what psychologists call a “theory of mind”—the
abilitytounderstandanotherperson’smentalstate. Tounderstandwhy,considerthemost basic
form of bilateral negotiation between a buyer and a seller; even the simplest
backand-forthprocess ofprice discovery requires thatthebuyer understand themotives ofthe
seller,andviceversa. Infact,tocomputetheequilibriumprice—ashypothesizedbyrational
expectationsandefficientmarketstheory—requiresanunendingrecursivechainofreasoning,
asifbuyerandsellerweretrappedinahallofmirrors: thesellerknowsthatthebuyerknows that the
seller knows that the buyer knows that the bid is too high, etc. In other words, market
equilibrium requires arather sophisticated theory ofmind, and presumably a high
28
levelofabstractthought.
Intheearly1990s,achancediscoverybyagroupofresearchersattheUniversityofParma
38ledbyGiacomoRizzolattishowedthatperhapsthe“theoryofmind”wasnotveryabstract
atall,buthardwiredintothestructureofthebrainitself.Usingrecordingmicroelectrodes
generationsmoreadvancedthantheonesusedinOldsandMilner’sexperiment,Rizzolatti
andhisgroupfoundtherewerespecificneuronsinthemacaquemonkeybrainthatresponded
to“mirrored”motionsinothers. Forinstance,acertainneuroninthepremotorcortexwould
firewhenamacaquegraspedanobjectaswellaswhenanexperimentergraspedanobject.
Thiswasdirectphysicalevidencethatthemacaquecouldunderstandtheactionsofothersin
termsofitsownexperience,evenacrossspecies! Inshort,themacaquehadabasic“theory
ofmind”hardwiredintoitsneurophysiology.
39Thisdiscoveryof“mirrorneurons”wasentirelyunexpected.
Whilesomeneuroscientists
hadjokinglyspokenof“grandmotherneurons”,neuronsthatwouldfirewhenindividualssaw
theirgrandmothers,noneurologistexpected abasicsysteminthebrainforunderstanding
thebehaviorofothersintermsofone’sownphysicalactions. Infact,thediscoverywasso
outofleftfieldthattheprestigiousscientificjournalNature declinedtopublishRizzolatti’s
manuscriptbecauseitseditorsbelieveditlacked“generalinterest”.Thisrejectionnotwithstanding,i
nashorttimeRizzolattiandhisteamdetectedmirrorneuronsinhumansaswell,
notthroughtheuseofmicroelectrodes,butthroughtheuseofpositronemissiontomography (PET),
which showed neural activity in the analogous areas ofthe human brain as in the
macaqueinresponsetomirroredbehavior. Likeourevolutionarycousins,wehumanshave
neuronsthatautomatically“lightup”insympathytotheactionsofothers.
Nowincontrasttothecommonneuroscientificapproachofdeterminingthefunctionof
partsofthebrainbystudyingthebehaviorofindividualsinwhomsuchpartsaredamaged,
inthecaseofmirrorneurons,theapproachhasbeenreversed. Weknowwhattheneurons
do,butwedon’tyetknowhowtheyaffectbehavior. Onehypothesis,proposedbyRizzolatti and
others, is that a deficit in the brain’s mirror mechanism may be involved in autism
spectrumdisorder,thatcomplexsyndromeoflearning,social,communicative,andemotional
deficits. People with autism often have difficulty in understanding other people’s motives
38DiPellegrinoetal.(1992).
39RizzolattiandFabbri-Destro(2010).
29
40and,therefore,connectingsocially,suggestingtheyhaveanundevelopedtheoryofmind,as
theBritish neuroscientist SimonBaron-Cohenbelieves.Here, however, we don’thave to
lookforspecific neurologicalcase studies amongautistic children. Every oneofushas, as
children,passedthroughlifestageswhereourowntheoriesofmindwereundeveloped.
It is strange to think that at some point before the age of four, we were not able to
understandthatanotherperson,perhapsaparent,couldbelievesomethingthatweourselves
knewwasnottrue. Asadults,ofcourse,mostofusarecomfortablewiththeideathatother
peoplemightbemistaken. Forthoseofuswhoareparents,theknowledgethatachildunder
theageoffourismentallyincapableofunderstandingthisisvaguelycomforting,particularly
whenwearefacedwithwhatlookslikeotherwiseunreasonablebehavior. However, bythe
timemostchildrenreachtheageoffour,theyareabletodealwithwhatpsychologistscall “first-order
false belief”. Sentimentally, we might pinpoint that age as the time when we
learnourparentsaren’tinfallible,butinreality,that’stheageourbrainshavedevelopedto
thepointwherewecanunderstandthatotherpeoplecanbefallible. It’sanimportantstep
onthepathwaytoafull“theoryofmind”.
fact, afour-year-oldmightbe abletounderstand astatement like, “Alanthinks his
Christmaspresentisinredwrapping,butthepresentisreallyinthegreenwrapping”. But
atypicalfour-year-oldwouldnotunderstandastatementlike,“BethanythinksAlanthinks
hisChristmaspresent isblue,andAlanthinkshisChristmas presentisred,butit’sreally green”.
Theabilitytounderstandasecond-orderfalsebelief,insteadoffollowingnaturally
andrecursivelyfromtheabilitytounderstandafirst-orderfalsebelief,takesafewmoreyears to
develop. In general, a seven-year-old can understand a story with a second-order false
belief. Thismeanstheirtheoryofmindisrichenoughnotonlytomodelanotherperson’s
mentalstate,butalsotomodelanotherperson’smodelofaperson’smentalstate.
Afouryear-oldcanseeonemirrordeepintothehallofmirrorsofintention,whileaseven-year-old
canseetwomirrorsdeep.
41In
How far does this hall of mirrors extend? We might suspect, on purely theoretical
grounds, that the potential for infinite regress is present in humans, even if rarely used. After
all, the English language can support infinite levels of clauses in its grammar, as in
40Baron-Cohen(1989).
41PernerandWimmer(1985).
30
42thenurseryrhyme“Thisisthecatthatkilledtheratthatatethemaltthatlayinthehouse
thatJackbuilt”,andsoon.
Ontheotherhand,wemighttrytoconstructamentalexperimentaboutathird-orderfalsebelief—Cla
ytonthinksthatBethanythinksthatAlanthinks
etc.—andcometotheconclusionthatit’sratherdifficult. Infact,psychologicaltestshave shown
that normal adults start making significant errors when answering questions about
thefifth-ordertheoryofmind.
This hasimplications fortheassumption ofhuman rationalityin theEfficient Markets
Hypothesis. Itisnotverydifficulttoconstructascenariowherecorrectknowledgeregarding
another individual’s intentions five layers removed from a given transaction has economic
implications, whether in a complicated mergers and acquisitions deal, in the terms of an
exotic financial derivative, or even in the picks and trades of the NFL draft. But if it’s
impossibleforallbutaveryfewchessgrandmasterstoholdsuchachainofintentionsasa
singlethought—impossibleinthesamewaythatayoungchildliterallycannotunderstand
thathisparentdoesnotknowwherehisblanketis—howcananinvestoralwaysactrationally
tomaximize hisorherprofit? Alternatively, iftheinvestorfailstoactrationally,howcan
otherinvestorsknowtheyaretakingsuccessfuladvantageofthefailure? Thismightinvolve
asixth-ordertheoryofmind. Whilethearbitragemechanismcancorrectmisjudgments, it
reliesontheabilityofinvestorsinthemarkettorecognizewhenacorrectjudgmentbythe
markethastakenplace. Insomecases,thisexpectationissimplyunrealistic.
8 Interactions
Althoughneurosciencehashadmanybreakthroughsinthelastfewdecades,oneofthemost
importantquestionsabouthumancognitionhasyettobeanswered: howdotheindividual
components of the brain interact to produce observed human behavior? We now know a
great deal more about how fear and greed are physiologically generated, but what can we
say abouthow an individual will respond toa20%decline inhis retirement portfolio?
Despitethefactthatthefight-or-flightresponsemaybetriggeredbysuchanevent,notall
individualswillreactinthesamemanner—somemaypanicandswitchtheirportfoliotocash
immediately; others may notreactatall. Can neuroscience provide anyinsight into these
42Kinderman,Dunbar,andBentall(1998).
31
individual differences and the underlying mechanisms by which such heterogeneity arises?
Fromtheeconomist’spointofview,thesekindsofquestionsarethemostrelevant;theyare
alsothemostdifficulttoanswerfromtheneuroscientificperspective.
Whilewedon’tyethaveacompletetheoryofhowthebrainworks,thereareafewobservationsthat
hintathowthevariouscomponentsofthebraininteract. Thefirstobservationis
thatnotallneuralcomponentsarecreatedequal. Fromanevolutionaryperspective,certain
componentsaremucholderthanothersandarefoundinmanyspeciesinadditiontoHomo sapiens.
Therefore, these commoncomponents aremorelikely toengageinfunctions that
arecriticalforbasicsurvivalacrossallspecies. Forexample,painreceptorsexistinvirtually
allmammalsandreptiles;hencepainavoidanceandfearconditioningisequallyubiquitous
andobviouslycriticalforsurvival. Thisuniversalityimpliesacertainpriorityinitsimpact onbehavior:
painavoidanceandfeartrumpallotherneuralcomponentsundersufficiently
threateningcircumstances,astheyshould. Whilea20%declineinone’sretirementportfolio
mightnotleadtothesameresponseacrossadiversepopulationofinvestors,aragingfirein
acrowdedtheaterwill.
43However,
thebehaviorofHomo sapiens canbeconsiderablymoresubtle,asillustrated
bytheremarkablestoryofthe27-year-oldmountainclimberAronLeeRalston,whoseordeal
waschronicled inthegrippingfilm127 Hours. OnApril26,2003,Ralstonwasclimbinga
3-footwidecrevasseinBluejohnCanyoninaremoteregionofsoutheasternUtahwhenan
800-poundboulderslippedandpinnedhisarmtothewallofthecrevasse. Hewastrapped
inthecrevasseforfivedays,andhefinallyescapedbyamputatinghisrightarmbelowthe
elbowwithadullknife. ThisstoryisincrediblebecausewerecognizethatRalstonvoluntarily
inflicted extraordinarypainonhimself,indirect contradictiontoourmostbasicinstinct
43To
appreciate the magnitude of the pain Ralston underwent, the following is a short summary of Ralston’s
self-amputation written by a mountain-climbing blogger, Shane Burrows
(http://climbutah.com/Roost/bluejohn2.htm). WARNING:Squeamishreadersshouldreadnofurther:
Ralstonpreparedtoamputatehisrightarmbelowtheelbowusingtheknifebladeonhismultitool.
Realizingthatthebladewasnotsharpenoughtocutthroughtheboneheforcedhisarm
againsttheboulderandbrokethebonessohewouldbeabletocutthroughthetissue. First he brokethe
radius bone, whichconnects the elbowto the thumb. Within a few minutes he
crackedtheulna,theboneontheoutsideoftheforearm. Nextheappliedatourniquettohis arm. He then
used his knife blade to amputate his right arm below the elbow. The entire
procedurerequiredapproximatelyonehour.
For those interested in the gory details, an even more graphic description is provided by Ralston (2004,
pp.281–285).
32
of pain avoidance. How was he able to accomplish this feat? Presumably, he was able to
overridehispain-avoidancecircuitrybycreatinganalternatescenarioinhismindthatwas
considerablymorerewarding—despitethefactthatitincludedthepainfulamputation—than
dyingaloneinthecrevasseonthatday.
44Ourcapacitytocreatecomplexscenarios,purefigmentsofoursubstantialimaginations,
isoneofthemostimportantevolutionary advantageswe’ve developed, anditseems tobe unique
to our species. The portion of the brain responsible for these complex thoughts is
knownastheprefrontalcortex,andwhilesimilarstructuresdoexistinothermammals,Homo
sapiensseemstohavethelargestandmosthighlyconnectedversion.45Neuroscientistshave
shown thatmany oftheuniquely human traits such aslanguage, mathematical reasoning,
complex planning, selfcontrol, anddelayed gratificationoriginateintheprefrontalcortex.
Forthisreason,thisregionissometimesreferredtoasthe“executivebrain”. LiketheCEO of a
well-run company, the prefrontal cortex is responsible for developing a vision for the
organization, monitoring the performance of the various divisions and subordinates, and
making resource-allocation decisions that weigh the costs and benefits of each competing
division’s goals so as to maximize the chances of achieving the overall objectives of the
organizationwhileprotectingitfromcurrentandpotentialthreats. Thiscorporatehierarchy
isnotsimplyausefulanalogy—it’sactuallypartofourneurophysiology.This“commandand-control
center” was the region of the brain destroyed in Phineas Gage’s unfortunate
accident,withpredictableconsequences.
Theexecutivefunctionsthathumanbrainspossessallowustoengageinfarmorecomplex
behaviors than otherspecies. A simple manifestation ofthis difference is the factthat we can
more easily predict the behavior of other animals than those ofhumans. Greatwhite
sharkscircletheirpreybeforestriking,Canadiangeesemigratesouthduringthewinter,and
ocean-dwelling Pacific salmon return to freshwater rivers to lay their eggs. While humans
exhibitcertainpredictabletraitsaswell(asignificantfractionofNewEnglandersalsomigrate
southforthewinter!),thenumberofpossiblebehaviorsgeneratedbytheprefrontalcortexis
exponentiallygreater,simplybecauseofourabilitytoimagineandchoosefromamultitudeof
hypotheticalrealities. Manyofthesealternaterealitiesarehighlyelaboratewhat-ifscenarios
44Schoenemannetal.(2005)andSmaersetal.(2011).
45Botvinick(2008).
33
46thatcanmoveustodoextraordinarythings.
AccordingtoAronRalston,itwasthefollowing
hypotheticalrealitythatallowedhimtodotheunthinkable:
A blond three-year-old boy in a red polo shirt comes running across a sunlit
hardwoodfloorinwhatIsomehowknowismyfuturehome. Bythesameintuitive
perception, I know the boy is my own. I bend to scoop him into my left arm, using
my handless rightarmtobalance him, and we laughtogetherasIswing him up to my
shoulder... Then, with a shock, the vision blinks out. I’m back in the canyon,
echoes of his joyful sounds resonating in my mind, creating a subconscious
reassurancethatsomehowIwillsurvive thisentrapment. Despite
havingalreadycometoacceptthatIwilldiewhereIstandbeforehelparrives,
nowIbelieveIwilllive.
Thatbelief,thatboy,changeseverythingforme.
Ralston was not married or engaged at the time, and had no children. In August 2009,
RalstonmarriedJessicaTrusty,andtheirfirstchild,Leo,wasborninJanuary2010.
The prefrontal cortex is a remarkable piece of neural machinery that, in the blink of an
eye on an evolutionary time scale, has allowed humans to dominate their world and
spreadtovirtuallyevery typeofenvironment onthisplanetanditsmoon. Theprefrontal
cortexistheclosestthingtorationalexpectationsandHomoeconomicusthatthebrainhas to offer
to economists. If agents maximize expected utility subject to budget constraints, or optimize
portfolios via quadratic programming, or engage in strategic subterfuge in a
dynamicbargainingcontext,theywillbeusingtheprefrontalcortextodoso.
Butlikeanyorganofanylivingbeing,therearelimitstoitscapabilities. Asimpressive
anduniqueasthehumanprefrontalcortexis,itcan’toperateinstantaneouslyorindefinitely. In fact,
in certain circumstances, it doesn’t operate at all. For example, individuals who faint when
confronted with shocking news do so through a sudden loss of blood pressure thatshuts
down theprefrontalcortex, causing themtoloseconsciousness. Aless extreme illustration of
the limitations of the prefrontal cortex is “decision fatigue”, a phenomenon recently
documented among a group of judges presiding over parole hearings for Israeli prisoners.
During each day of hearings, there were two food breaks that divided the day into three
distinct sessions, and researchers found a striking pattern over these sessions: the judges
rendered favorable paroledecisions about65%ofthe time atthe startofthese sessions, but the
percentage would systematically decline to nearly 0%by the end ofeach
46Ralston(2004,p.248).
34
session.4748Itappearsthatdifficult decisions canbementally taxinginsome manner, soas
thesesessionsworeon,thejudgesbecamemoreinclinedtoavoidsuchdecisionsbydenying
parole. However,afterthefoodbreaks(alate-morningsnack,andthenalunchbreak),the
judgeswererefreshedandreadytoresumetheircomplexdeliberations;henceparoleratesat
thebeginningofthefollowingsessionwereconsiderablyhigher. Thefactthattheincreased
paroleratesfollowedfoodbreaksisconsistentwithrecentfindingsthatglucosecanreverse
theeffectsofdecisionfatigue.Apparently,itreallyistruethatoneshouldnevernegotiate
onanemptystomach!
49AswiththosecorporateCEOswholeadtheircompaniesastray,therearemanypathsto
failure.
Earlybehavioralmodelsofeconomicchoicerecognizedthesepathologiesandmodeled
theireffectsexplicitlytoproducemorerealisticconsumersavingandspendingpatterns,such
asthe“behaviorallife-cyclemodel”ofHershShefrinandRichardThaler.50Theseinsights led to a
significant innovation in retirement savings plans, pioneered by Shlomo Benartzi
andThaler—the ideaofallowingparticipants to“optout”insteadofaskingthemto“opt in”, and
reducing thenumber ofchoices so they don’tover-diversify intoinvestments that
theydon’treallyunderstandorwant.51Theseseeminglysuperficialchangescanhavehuge positive
impact on the participation rateof401(k) plans, which everyone agrees is agood thing.
Inoneempirical study, participationratesforthestandardopt-inplanwas around 20% after three
months of employment and increased gradually to 65% after 36 months;
withautomaticenrollment,theparticipationrateofnewemployeesjumpedimmediatelyto 90%,
and the fact that participation increased to 98% after 36 months suggests that few
individualsoptedout.Notonlydidthissimplechangeincreasetheparticipationrate,it
alsocausedemployeestojoinsooner,whichobviouslybenefitslong-termwealthcreation.
52These
examples highlight the complexity and subtlety of Homo sapiens, but they also
offerhopethatwecanonedaydevelopamorecompleteunderstandingofhumanbehavior
thatintegrateseconomics,psychology,andneuroscienceinmutuallybeneficialways.
47SeeDanziger,Levav,andAvnaim-Pesso(2011).
48Tierney(2011).
49ShefrinandThaler(1988).
50BenartziandThaler(2004).
51MadrianandShea(2001).
52Lo(2010).
35
9 PolicyImplications
Althoughtheperspectiveoutlinedinthischapterhasbeenlargelyqualitative,nevertheless
itdoesofferseveralpracticalimplicationsforpolicymakersfocusingonfinancialreformand
systemicrisk.
53Oneimmediateimplicationisthatindividualbehaviorisacomplicatedanddynamicmedley
ofseveral decision-making neuralcomponents, including primitive hardwired responses such
as fight-or-flightandmore refined processes such as logicaldeliberationandstrategic planning.
Assumingthatindividualsorpopulationsalwaysbehaveinonlyonemannerorthe
otheristoosimplistic andmay leadtoineffective orcounterproductive policies. Financial
markets and their participants are rarely always rational, nor are they always emotional.
Instead, they engage in both types of mental processes and are constantly adapting and
evolvingtonewsetsofcircumstances. Underthis“AdaptiveMarketsHypothesis”,manyof
thetenetsofmarketefficiencyandrationalexpectationsmaynotholdatalltimes,butthey
doserveasusefulbenchmarksthatrealitymayeventuallyapproximateundercertainconditions.Inp
articular,ifenvironmental conditionsarerelatively stable, thentheprocessof
naturalselectionwilleventuallyallowmarketparticipantstosuccessfullyadapttosuchconditions,af
terwhichthemarketwillappeartobequiteefficient. However,iftheenvironment is unstable, then
market dynamics will be considerably less predictable as some “species” lose their
competitive edge to others, and the market may appear to be quite inefficient.
Indeed,theevolutionarytheoryof“punctuatedequilibrium”—inwhichinfrequentbutlarge
environmentalshockscausemassiveextinctionsfollowedbyaburstofnewspecies—maybe
justasrelevanttoeconomiccontexts.
Ifpunctuatedequilibriaalsocharacterizesfinancialmarkets,thenpoliciesdesignedunder
theassumptionsofrationalitywillbeinappropriateduringperiodsoffinancialdistress,and
policiesdesignedtodealwithperiodsofdistresswillbeinappropriateduringperiodsofcalm.
TheAdaptiveMarketsHypothesissuggeststhatthemostdurableformofregulationisone
thatadaptstochangingenvironmentsandpopulations. Countercyclicalcapitalrequirements
isoneexample,buttherearemanyotherpossibilitiesforrevampingexistingregulationsto
bemoreresponsivetocurrentsystemicexposures.
53Lo(1999,2004,2005).
36
Anotherimplicationoftheneuroscience perspective
isthatthereisabiologicallymandatedhierarchyofthecomponentsofthebrainthatshouldberespect
ed. Fear,particularly
fearoftheunknown,overridesmostotherdecision-makingcomponents,andoncetriggered,
thiscircuitcanbeverydifficulttointerrupt.
Centralbankersarenostrangerstothisconcept,whichliesattheverycoreofabankrunandoftherais
ond’ˆetreofthecentralbankas lenderoflastresort.
Butitappliesmuchmorebroadly;hencepolicymakerswoulddowellto
focusmoreonclear,accurate,timely,andregularcommunicationwiththepublicthroughout
periodsofsignificantturmoil,irrespectiveofthecause.
Onlythroughsuchtrustedcommunicationcanfearbesuccessfullymanagedand,ultimately,elimin
ated. FDRwasmoreright
thanheknewwhenhesaid,“Theonlythingtofearisfearitself”,butheshouldhaveadded that fear is,
indeed, a fearsome force of nature that should be greatly feared and actively managed.
54If
the active management of fear involves greater communication and transparency, a
prerequisiteisthecollectionanddisseminationofinformationregardingsystemicrisk—itis
atruismthatonecannotmanagewhatonedoesnotmeasure. Therefore,thestartingpoint
foranyseriousdiscussionofmacroprudentialpolicy-makingandsystemicriskmanagement
mustbetherawdataonwhichriskmeasuresarebased. Ofcourse,financialdataareoften quite
sensitive, and individual and institutional privacy must be guaranteed. Fortunately,
measures of systemic risk can be derived without infringing on such privacy because they
aggregateinformationoverallfinancialinstitutions. Afterall,theverymeaningofsystemic
riskinvolvestheentirefinancialsystem;henceaggregationshouldservetoprotecttheprivacy
ofindividualsundermostcircumstances.Thebenefitsofpublicizingsuchmeasurescould be as
significant as the air-quality measures published by the Environmental Protection Agency or
the hurricane warnings issued by the National Weather Service. In bothcases,
it’sonlythroughtheconstantfeedbackofthesepublishedindicatorsthatweknowhowto change
ourbehavior accordingly, i.e., by imposing more stringent auto-emission standards
ororderingevacuationsofareasinthepathofthehurricane.
Theimportanceofmeasurementgoeshand-in-handwiththeexecutivefunctionofdelayed
gratificationandpainavoidance. Anindividualorinstitutioncanbeexpectedtovoluntarily
54Inaddition,moresophisticatedmethodsofpreservingprivacysuchastheencryptionalgorithmsofAbbe,
Khandani,andLo(2011)maybeimplementedinsituationsinvolvingparticularlysensitiveinformation.
37
reduce or discontinue an otherwise currently pleasurable or profitable activity under only
twoconditions: thechangemayresultinevengreaterpleasureorprofitlater,orthechange
mayreducethelikelihoodofpaininthefuture. Absentbothoftheseconditions,theneural incentives
to reduce risk are also absent; hence the role of publicizing risk measures is to provide all
parties with the appropriate information on which they can weigh the fear of future losses
against the pleasure of current gains. As Damasio’s elegant explication of
rationalityshows,onlythroughtheproperbalanceoffear,greed,andotheremotionaldebits
andcreditscanwemakegooddecisions.
55Thebehavioralfeedbackloopcreatedbyaccuratesystemic
riskmeasuresisarelatively simple
example of how we adapt to changing environments; a more sophisticated version
involvesdefinitiveforensicanalysesofprioreventsthatleadustochangeourbehavior. Perhaps the
best illustration of this type of learning behavior is the National Transportation
SafetyBoard(NTSB),theindependentinvestigatoryagencychargedwiththetaskofanalyzingalltra
nsportationaccidents. Intheevent ofanairplanecrash,theNTSBassembles a seasoned team of
engineers and flight-safety experts who are immediately dispatched to
thecrashsitetoconductathoroughinvestigation,includinginterviewingwitnesses,poring
overflightlogsandmaintenancerecords, siftingthroughthewreckagetorecover theflight
recorderor“blackbox”,and,ifnecessary, literallyreassembling theaircraftfromitsparts
soastodeterminetheultimatecauseofthecrash. Onceitsworkiscompleted, theNTSB
publishesareportsummarizingtheteam’sinvestigation,concludingwithspecificrecommendation
sforavoidingfutureoccurrencesofthistypeofaccident. Thereportisentered into
asearchabledatabasethatisavailabletothegeneralpublic,andthishasbeenoneofthe
majorfactorsunderlyingtheremarkablesafetyrecordofcommercialairtravelintheUnited States.
Financialblowupsare,ofcourse,considerablylessdire,generallyinvolvingnolossoflife.
However, astheFinancialCrisis of2007–2009morethanamply illustrated, thedisruption
toeconomiclifecanbedevastatinginitsownright,andwithfarbroaderandlonger-lasting impact
than a plane crash. For these reasons, an independent organization dedicated to
investigating, reporting, and archiving the “accidents” of the financial industry may yield
significantsocialbenefitsinmuchthesamewaythattheNTSBhasimprovedtransportation
55Seehttp://www.ntsb.gov/ntsb/query.asp.
38
safetyenormouslyforallairtravelers. Bymaintainingteamsofexperiencedprofessionals—
forensicaccountants,financialengineersfromindustryandacademia,andsecuritiesandtax
attorneys—thatworktogetheronaregularbasistoinvestigatethecollapseofeverymajor
financialinstitution,a“CapitalMarketsSafetyBoard”(CMSB)wouldbeabletodetermine
quicklyandaccuratelyhoweachcollapsecameabout,andtheresultingreportswouldbean
invaluable source ofideas forimproving financialmarkets andavoidingsimilar debacles in
thefuture.
It is unrealistic to expect that market crashes, panics, collapses, and fraud will ever
becompletely eliminatedfromourcapitalmarkets, butwe shouldavoidcompoundingour
mistakes by failingtolearnfromthem. Amoreinformedinvesting publicwillbetheonly
meansofconqueringourfearsandreestablishingtheleveloffaithandtrustthathasmade
U.S.financialmarketsamongthemostliquidandefficientintheworld.
10 Conclusion
OneofthemostsignificantconsequencesoftheFinancialCrisisof2007–2009istherealization
thatthe intellectual framework ofeconomics andfinance is incomplete inseveral respects.
While the Financial Crisis has exposed some of the limitations of neoclassical economics,
critiquesoftraditionaleconomictheoryhavebeenaccumulatingfromwithintheprofession
forquitesometime. Theconflictbetweentherationalexpectationsparadigmofeconomics
andthemanybehavioralbiasesdocumentedbypsychologists, behavioraleconomists,
sociologists,andneuroscientistshasbeenhotlydebatedfordecades. Rationalexpectationsand
its close cousin, the efficient markets hypothesis, have come under fire recently because of
theirapparentfailureinpredictingandexplainingthecurrentfinancialcrisis.
Some of this criticism is undoubtedly misplaced populist anger atthe life-altering
economicconsequences oftheburstingofthehousingbubblein2006,anditsknock-oneffects on
the financial system, employment, and real economic growth in its aftermath. In such an
emotionally charged atmosphere, it is easy to forget the many genuine breakthroughs
thathaveoccurredineconomicsoverthelasthalf-centurysuchasgeneralequilibriumtheory,gamet
heory,growththeory,econometrics,portfoliotheory,andoption-pricingmodels.
Butanyvirtuecanbecomeavicewhentakentoanextreme. Thefactthatthe2,319-page
39
Dodd-Frankfinancial reformbill was signed into law on July 21, 2010—sixmonths before the
Financial Crisis Inquiry Commission submitted its January 27, 2011 report, and well before
economists have developed any consensus on the crisis—underscores the relatively
minorscientificrolethateconomicshasplayedinrespondingtothecrisis. ImaginetheFDA
approvingadrugbeforeitsclinicaltrialsareconcluded,ortheFAAadoptingnewregulations
inresponsetoanairplanecrashbeforetheNTSBhascompleteditsaccidentinvestigation.
Therearelegitimateargumentsthattherigorousandinternallyconsistenteconomicmodels of
rational self-interest—models used implicitly and explicitly by policymakers, central
bankers,andregulatorstoformulatepolicy,manageleverage,andreininrisk-takinginthe
economy—are deficient. Even the most sophisticated stochastic dynamic general
equilibrium models did not account for the U.S. housing market boom and bust, nor were
they richenoughtocapturetheconsequencesofsecuritization,creditdefaultinsurance,financial
globalization,andthepoliticaldynamicsunderlyingFannieMaeandFreddieMac.
56However,weshouldn’tbetooquicktodismissthepositiverolethatmarketshaveplayed,
certainly
throughout history but even during the buildup to the crisis. In an April 2006
publicationbytheFinancialTimes,reporterChristineSeniorfiledastoryontheenormous
growthoftheCDOmarketinEuropeoverthepreviousyears,quotingNomura’sestimateof
$175billionofCDOsissuedin2005. WhenaskedbySeniortocommentonthisremarkable
growth,CianO’Carroll,EuropeanheadofstructuredproductsatFortisInvestments,replied, “You
buy a AA-rated corporate bond you get paid Libor plus 20 basis points; you buy a AA-rated
CDO and you get Libor plus 110 basis points”.Did investors ever ask why
bondswiththeidenticalratingwereoffering90basispointsofadditionalyield,andwhere
thatyieldmighthavebeencomingfrom? EvenattheheightoftheCDOmarket,itseems that the
crowd was still quite wise. It may not have been the disciples of the Efficient
MarketsHypothesisthatweremisledduringthesefrothytimes,butmorelikelythosewho
wereconvincedtheyhaddiscoveredafreelunch.
Rather than discarding rationality altogether, a more productive response may be to
confront the inconsistencies between economic models of behavior and those from other
disciplines—and attempttoreconcile them andimprove ourmodels intheprocess. While
frustrating,contradictionsoftenpresentopportunitiesfordevelopingadeeperunderstanding
56Senior(2006).
40
57ofthephenomenainquestion.
Inparticular,neuroscience,psychology,anthropology,sociology,andeconomicsallintersectwithr
especttohumanbehavior,andwhenthesedisparate
fieldssharethesameobjectofstudy,theirrespectivetheoriesmustbemutuallyconsistentin
theirimplications. Forexample, neurophysiologicalmechanisms ofriskprocessingmustbe
consistent with psychological experiments involving human subjects choosing among risky
alternatives;otherwise,flawsexistinoneorbothofthesebodiesofknowledge.Byreconcilingtheinc
onsistencies andcontradictions between disciplines, we candevelop abroader
anddeeperunderstandingofHomosapiens.
Thisapproachhighlightsthevalueof“consilience”,atermreintroducedintothepopular lexicon
by the great evolutionary biologist E. O. Wilson (1998), who attributes its first
usetoWilliamWhewell’s 1840treatiseThePhilosophyofthe InductiveSciences,inwhich Whewell
wrote: “The Consilience of Inductions takes place when an Induction, obtained fromoneclass
offacts, coincides withanInduction, obtainedfromanotherdifferent class.
ThisConsilienceisatestofthetruthoftheTheoryinwhichitoccurs”. Inthischapter,I
hopetohavefacilitatedtheconsiliencebetweenfinancialeconomicsandtheneurosciences.
Fromtheneurosciencesperspective,itisnotsurprisingthattherehavebeen17bankingrelated
national crises around the globe since 1974, the majority of which were preceded by periods
of rising real-estate and stock prices, large capital inflows, and financial liberalization.
Extended periods ofprosperity act as an anesthetic in the human brain, lulling investors,
business leaders, and policymakers into a state of complacency, a drug-induced
stuporthatcausesustotakerisksthatweknowweshouldavoid. Inthecaseofthe
¨uberfraudsterBernardMadoff,seasonedinvestorswereapparentlysuckedintothefrauddespite
theirbetterjudgmentbecausetheyfoundhisreturnstootemptingtopassup. Inthecaseof
subprimemortgages,homeownerswhoknewtheycouldnotaffordcertainhomesproceeded
nonetheless,becausetheprospectoflivinglargeandhome-priceappreciationwastootemptingtop
assup. Andinvestorsinmortgage-backedsecurities,whoknewthattheAAAratings
weretoooptimisticgiventheriskiness oftheunderlyingcollateral,purchasedthesesecuri57Of
course, in many cases, implications may not overlap. The particular biochemical structure of the
neurotransmittersinvolvedinfearlearninghasnodirectbearingonthe behavioraloriginsoftime-varying
stockmarketvolatility,socheckingforconsistencybetweentheformerandthelatterisunlikelytoyieldnew insights.
Butforthoseareasinvolvingfundamentaldriversandmechanismsofhumanbehavior,opportunities
forconsistencycheckswillariseoften,andweshouldtakeadvantageofthemwheneverpossible.
41
tiesanywaybecausetheyfoundthepromisedyieldsandpastreturnstootemptingtopass up.
Ifweaddtothesetemptationsaperiodoffinancialgainthatanesthetizes thegeneral
population—includingCEOs, chief risk officers, investors, regulators, andpoliticians—itis
easy tosee how tulip bulbs, Internet stocks, gold, real estate, securitized debt, and
fraudulent hedge funds could develop into bubbles. Such gains areunsustainable, and once
the lossesstartmounting,ourfearcircuitrykicksinandpanicensues,aflight-to-safetyleading
toamarketcrash. Thisiswherewearetoday.
Likehurricanes,financialcrisesareaforceofnaturethatcannotbelegislatedaway,but
wecangreatlyreducethedamagetheydowithproperpreparation. Inthelongrun,more
transparencyintothe“shadowbankingsystem”,moreeducationforinvestors,policymakers,
andbusiness leaders, andmorebehaviorallyorientedandadaptiveregulationwillallowus
toweatheranytypeoffinancialcrisis. Regulationenablesustorestrainourbehaviorduring
periodswhenweknowwe’llmisbehave; it’smostusefulduringperiodsofcollectivefearor greed
and should be designed accordingly. Corporate governance should also be revisited
fromthisperspective—if wetrulyvaluenaysayers duringperiodsofcorporateexcess, then
weshouldinstitutemanagementchangestoprotectandrewardtheirindependence.
With respect tothe future ofeconomics, E.O. Wilson (1998, p.182)makes
athoughtprovokingobservationincomparingtherateofprogressinthemedicalvs.
thesocialsciences:
Thereisalsoprogressinthesocialsciences,butitismuchslower,andnotatall
animatedbythesameinformationflowandoptimisticspirit...
Thecrucialdifferencebetweenthetwodomainsisconsilience:
Themedicalscienceshaveitandthesocialsciencesdonot.
Medicalscientistsbuilduponacoherentfoundationofmolecularandcellbiology.
Theypursueelementsofhealth
andillnessallthewaydowntothelevelofbiophysicalchemistry...
Socialscientistsbyandlargespurntheideaofthehierarchicalorderingofknowledgethat
unitesanddrivesthenaturalsciences. Splitintoindependentcadres,
theystressprecisioninwordswithintheirspecialtybutseldomspeakthesame
technicallanguagefromonespecialtytothenext.
Thisisabitterpillforeconomiststoswallow,butitprovidesacleardirectiveforimproving
thestatusquo.
Althougheconomicsoccupiesanenviablepositionamongthesocialsciences becauseof
itsaxiomaticconsistency anduniformity, Homo economicus isafictionthatcannolonger
bemaintainedinlightofmountingevidencetothecontraryfromalliedfieldslikepsychology
42
andthecognitiveneurosciences.
Fordisciplinesinwhichcontrolledexperimentationispossible,consiliencemaybelesscriticaltopro
gressbecauseinconsistenciescanbegeneratedand resolved within the discipline through
clever experimental design. Butfordisciplines such asfinancialeconomicsinwhich
controlledexperimentation ismorechallenging, consilience is an essential means for moving
the field forward. Even in fields where experiments are routine,consilience
canspeedupprogressdramatically. Therevolutioninpsychologythat
transformedthefieldfromalooselyorganizedcollectionofinterestingandsuggestiveexperiments
and hypotheses to a bona fide science occurred only within the last three decades,
thankstosynergisticadvancesinneuroscience,medicine,computerscience,andevenevolutionar
ybiology. Thiscouldbethefutureofeconomics.
If “a crisis is a terrible thing to waste”, then we have a short window of opportunity
beforeeconomicrecoverybeginstoweakenourresolvetoreformourintellectualframework and
regulatory infrastructure for the better. The fact that time heals all wounds may be
goodforourmentalhealth,butitmaynothelpmaintainoureconomicwealth. Policymakers
shouldconsidertheparallelsbetweenAronRalston’spredicamentinBluejohnCanyonand
thecurrenteconomicchallengestheyface. Whencaughtbetweenarockandahardplace,
noonewants todowhat Ralstoneventually did; in fact, ittookhimfive days tocome to his
fatefuldecision. The only way toachieve such anextraordinary outcome is todevelop a vision
of an alternate reality so compelling that it can justify the magnitude of
shorttermpainrequiredtoachieveit. Intheend,thisistheessenceofleadership—tounitethe
populationinasharedvisionthatisfargreaterthanwhatindividualscouldachieveleftto
theirowndevices.
43
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