Given the recent bursting of the housing bubble (let’s hope, at least, that we’ve hit rock bottom), Kevin Drum raises an interesting issue:
Bubbles come along with some frequency these days, always with some shiny new reason for bankers to become irrationally exhuberant. Just in the last couple of decades we’ve seen bubbles in S&Ls (safe as houses!), South American countries (sovereign states never default!), junk bonds (greed is good!), dotcoms (eyeball, not profits!), and now housing (safe as houses!). Every time, it turns out that there’s nothing new at all. The economy has not been fundamentally changed, risk and reward are still roughly proportional, profit still drives stock prices, and supply and demand still function about the same way they always have.
And there’s one other thing that always stays the same: the object of the particular bubble that’s just burst comes under increasing scrutiny, but nothing is ever done to try to address the underlying issues in the finance industry which, left to its own devices, will simply move along and create a new bubble somewhere else in a few years.
Why are bubbles so common? I think part of the answer can be found, not surprisingly, in the quirky calculations of the human brain. Look, for example, at this experiment, published in May in PNAS. A group of researchers led by Read Montague had people play an investment game while their brain was imaged in an fMRI machine. At the beginning of the game, each subject was given $100 and some basic information about the “current” state of the stock market. Each person then chose how much money to invest in the market. After making up their mind, the players nervously watched as their investments either rose or fell in value. The game went on like this for twenty rounds.
The stock markets used during the experiment weren’t random simulations. Rather, the scientists used data from famous historical markets, most of which were classic financial bubbles. Subjects in the experiment “played” the Dow of the late 1920’s, the Nasdaq of 1998, the Nikkei of 1986 and the S&P 500 of 1987. This let the scientists monitor the neural responses of investors during real-life booms and the inevitable crashes.
After just a few rounds, the scientists started to pick up a strong neural signal that seemed to be driving many of the investment decisions. Take, for example, this experimental situation. A player decides to wager 20 percent of his total portfolio in the market, which is a rather conservative bet. Then, he watches as the market rises dramatically in value. (Perhaps he’s playing the Nasdaq in the late 90’s.) At this point, the investor experiences a strong feeling of regret. When he contemplates the counterfactual – what if I’d invested all of my money in the market – he comes to the correct conclusion that he would have made much more money. What’s interesting about this experiment is that the scientists were able to actually see this regret signal in the brain, which was manifested as a swell of activity in the ventral caudate, an area rich in dopamine neurons.
What’s the purpose of all this “fictive learning”? Our mind is busy figuring out the difference between the return “that could have been” and the actual return. This calculation strongly influences our future decisions. The more we regret a decision, the more likely we are to do something different the next time around. As a result, investors in the experiment naturally adapted their investments to the ebb and flow of the market. When the market was going up, this meant that their automatic counterfactuals were persuading them to invest larger and larger amounts in the market. After all, if they’d made a certain amount of money by investing 50 percent of their portfolio in the market, imagine how much money the would have made if they’d invested everything?
Obviously, the ability to learn from counterfactuals is a crucial cognitive skill. It allows us to learn not just from experience, but from hypothetical scenarios. But I think this system goes bezerk during bubbles. The market keeps on going up, and so we are led to make larger and larger investments in the boom. (To not invest everything means that we are constantly regretting the gains we missed.) In this sense, every bubble is partly a symptom of the counterfactuals in the ventral caudate getting carried away.* We are so worried about the gains we haven’t realized that we forget to think about the possibility of a loss. But, of course, every bubble bursts.
*I’d also emphasize the role of financial news in making bubbles more common and exaggerated. Because we are constantly being inundated with breathless reports about various booms – see, for example, CNBC circa 1998 – we experience much more regret when we don’t invest in some shady dot-com company, or in Florida real estate, or in whatever the next boom will be. (My hope is that the next boom is in green technology, so at least we’ll get some valuable technology from all of our squandered investments.)