Brian Knutson, a very clever neuroeconomist at Stanford, sheds light on some of the cognitive biases currently holding back the economy over at Edge.org. From the perspective of the brain, uncertainty is hell:
The brain responds to uncertain future outcomes in a specific region, and ambiguity (not knowing the probabilities of uncertain outcomes) provokes even greater activation in this same region. Further, insular activation precedes risk avoidance in investment tasks, and is even more pronounced before people “irrationally” avoid risks (i.e., or violate the choices of a risk-neutral, Bayesian-updating “rational” actor). Inflict enough ambiguity on enough people and you can immediately sense that they might lean towards risk aversion.
What are some implications of these findings for the current crisis? Presently, we need to put a price on ambiguous derivatives (a job for the economists). As long as the value of these contracts remains unresolved, this could generate ultra-uncertainty, which will promote fear, which will keep money in peoples’ mattresses and out of the market. In the future, we should regulate (or incentivize) against contracts that resist pricing.
Colin Camerer has done of the best investigations of this uncertainty circuit. His experiment revolved around a decision making game known as the Ellsberg paradox. Camerer imaged the brains of people while they placed bets on whether the next card drawn from a deck of twenty cards would be red or black. At first, the players were told how many red cards and black cards were in the deck, so that they could calculate the probability of the next card being a certain color. The next gamble was trickier: subjects were only told the total number of cards in the deck. They had no idea how many red or black cards the deck contained.
The first gamble corresponds to the theoretical ideal of economics: investors face a set of known risks, and are able to make a decision based upon a few simple mathematical calculations. We know what we don’t know, and can easily compensate for our uncertainty. As expected, this wager led to the “rational” parts of the brain becoming active, as subjects computed the odds. This is how we think when we know (or at least pretend we know) what the value of some exotic mortgage security is, or how much money GM or GE will make in the next year. In other words, this is how investors are supposed to make decisions.
Unfortunately, this isn’t how the real world works, especially during a financial downturn. Right now, the gambles of financial investors are clouded by ignorance and ambiguity; we know something about what might happen, but not very much. Will these mortgage securities have any value in twelve months? Will GM go bankrupt? How long will the downturn last? When Camerer played this more realistic gambling game, the subjects’ brains reacted very differently. With less information, and thus more uncertainty, the players exhibited substantially more activity in the amygdala and in the orbitofrontal cortex, which is believed to modulate activity in the amygdala. In other words, they filled in the gaps of their knowledge with fear. That’s also what’s happening in the markets right now – nobody knows what will happen next, and so the end result is mild panic. Uncertainty sucks.
Camerer also tested patients with lesioned orbitofrontal cortices. (These patients are unable to generate and detect emotions.) Sure enough, because these patients couldn’t feel fear, their brains treated both decks equally. Their amygdalas weren’t excited by ambiguity, and didn’t lead them astray. Because of their debilitating brain injury, these patients behaved perfectly rationally. They weren’t scared by uncertainty.
Obviously, it’s difficult to reduce something as amorphous as “uncertainty” to a few isolated brain regions. But I think Camerer is right to argue that his “data suggests a general neural circuit responding to degrees of uncertainty, contrary to decision theory.”