The WSJ reports that the Fed is considering getting serious about popping financial bubbles:

Not so long ago, Federal Reserve officials were confident they knew what to do when they saw bubbles building in prices of stocks, houses or other assets: Nothing.

Now, as Fed Chairman Ben Bernanke faces a confirmation hearing Thursday on a second four-year term, he and others at the central bank are rethinking the hands-off approach they've followed over the past decade. On the heels of a burst housing-and-credit bubble, Mr. Bernanke now calls financial booms "perhaps the most difficult problem for monetary policy this decade."

With Asian property prices soaring and gold prices busting records almost daily, the debate comes at a critical time. Mr. Bernanke wants to use his powers as a bank regulator to stamp out bubbles, but the Senate Banking Committee, which will grill him later this week, is considering stripping the Fed of its regulatory power.

This strikes me as an important move, and not just because we're still trying to get out from under the rubble of a useless real estate boom. Financial history is largely a history of financial bubbles, from the Tulip mania of the Dutch Golden Age to the South Sea Bubble to the recent dot com disaster. We seem to be constantly careening from one irrational exuberance to another, with predictably depressing results. All is speculation.

The question, of course, is how to identify bubbles in the first place, which Bernanke associates with "undue risk taking". Call me crazy, but I think neuroscience can help. I'd suggest that the Fed call up Read Montague, a neuroscientist at the Baylor College of Medicine, who has done some incredibly interesting work on why the brain is so vulnerable to bubbles. Montague first grew interested in bubbles by accident, after helping to decipher the mechanics of dopamine neurons, which are constantly learning about the world by making predictions - if this, then that - and then comparing these predictions to what actually happens. Here's a snippet from How We Decide:

Although dopamine neurons excelled at measuring the mismatch between their predictions of rewards and those that actually arrived -- these errors provided the input for learning -- they'd learn much quicker if they could also incorporate the prediction errors of others. Montague called this a "fictive error learning signal," since the brain would be benefiting from hypothetical scenarios: "You'd be updating your expectations based not just on what happened, but on what might have happened if you'd done something differently." As Montague saw it, this would be a very valuable addition to our cognitive software. "I just assumed that evolution would use this approach, because it's too good an idea not to use," he says.

The question, of course, is how to find this "what if" signal in the brain. Montague's clever solution was to use the stock market. After all, Wall Street investors are constantly comparing their actual returns against the returns that might have been, if only they'd sold their shares before the crash or bought Google stock when the company first went public.

The experiment went like this: Each subject was given $100 and some basic information about the "current" state of the stock market. After choosing how much money to invest, the players watched nervously as their investments either rose or fell in value. The game continued for 20 rounds, and the subjects got to keep their earnings. One interesting twist was that instead of using random simulations of the stock market, Montague relied on distillations of data from famous historical markets. Montague had people "play" the Dow of 1929, the Nasdaq of 1998, and the S&P 500 of 1987, so the neural responses of investors reflected real-life bubbles and crashes.

The scientists immediately discovered a strong neural signal that drove many of the investment decisions. The signal was fictive learning. Take, for example, this situation. A player has decided to wager 10 percent of her total portfolio in the market, which is a rather small bet. Then she watches as the market rises dramatically in value. At this point, the regret signal in the brain -- a swell of activity in the ventral caudate, a reward area rich in dopamine neurons -- lights up. While people enjoy their earnings, their brain is fixated on the profits they missed, figuring out the difference between the actual return and the best return "that could have been." 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 markets were booming, as in the Nasdaq bubble of the late 1990s, people perpetually increased their investments.

But fictive learning isn't always adaptive. Montague argues that these computational signals are also a main cause of financial bubbles. When the market keeps going up, people are naturally inclined to make larger and larger investments in the boom. And then, just when investors are most convinced that the bubble isn't a bubble -- many of Montague's subjects eventually put all of their money into the booming market -- the bubble bursts. The Dow sinks, the Nasdaq collapses. At this point investors race to dump any assets that are declining in value, as their brain realizes that it made some very expensive prediction errors. That's when you get a financial panic.

Such fictive-error learning signals aren't relevant only for stock market investors. Look, for instance, at addiction. Dopamine has long been associated with addictive drugs, such as cocaine, that overexcite these brain cells. The end result is that addicts make increasingly reckless decisions, forgoing longterm goals for the sake of an intensely pleasurable short-term fix. "When you're addicted to a drug, your brain is basically convinced that this expensive white powder is worth more than your marriage or life," Montague says. In other words addiction is a disease of valuation: Dopamine cells have lost track of what's really important.

Montague wanted to know which part of the dopamine system was distorted in the addicted brain. He began to wonder if addiction was, at least in part, a disease of fictive learning. Addicted smokers will continue to smoke even when they know it's bad for them. Why can't they instead revise their models of reward?

Last year Montague decided to replicate his stock market study with a large group of chronic smokers. It turned out that smokers were perfectly able to compute a "what if" learning signal, which allowed them to experience regret. Like nonsmokers they realized that they should have invested differently in the stock market. Unfortunately, this signal had no impact on their decision making, which led them to make significantly less money during the investing game. According to Montague, this data helps explain why smokers continue to smoke even when they regret it. Although their dopamine neurons correctly compute the rewards of an extended life versus a hit of nicotine -- they are, in essence, asking themselves, "What if I don't smoke this cigarette?" -- their brain doesn't process the result. That feeling of regret is conveniently ignored. They just keep on lighting up.

One day, it might be possible to diagnose bubbles not by trying to decipher spikes in housing prices, but by sticking people in scanners and studying the intensity of their financial regret. Have their fictive-error learning signals pushed them to pursue excessive risk? Have they stopped thinking about the possibility of losses? Because these are the two essential psychological ingredients of every bubble: a greedy remorse that leads us to seek more and more profits, and a temporary suspension of loss aversion, so that we stop considering the possibility that, yes, even Cisco stock sometimes declines.

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Fascinating, but will this really cut the butter? There are, after all, legitimate reasons for dopamine to be released. Some gains, like some addictions, are sustainable; others not.

But the work points in an interesting direction. For example, might it be possible to determine what levels of dopamine are sustainable over a given period of time? If regulation of growth is calibrated to match a sustainable infrastructure -- be it neural networks or financial networks -- then perhaps there would be fewer or smaller bubbles.

Here's the problem I see with any scheme based on "putting people in scanners": suppose you spot a pattern of signals that convince you there is a bubble; so what? If there's no basis in financial data, it's hard for me to believe that the Fed will ever make a decision based solely on the results of the hypothetical scans.

Let's look at it another way-- from an arbitrage perspective. suppose a reasonable number of people start using these scans to make investment decisions. they are expected to become quite wealthy. After some number of bubbles, the market as a whole will become convinced and the results of these scans will be reflected in market prices. Does this mean there will no longer be any bubbles? I find it hard to believe that this is the case, but either way, there's no good economic argument for it, so the Fed again can't effectively make decisions.

If the Fed starts making decisions based on the scans, and suppose there is an index published for them (to be expected, if the Fed is using it for decisions making). The market will quickly incorporate this data into prices, and we're back at square one. The Fed still has no good economic reason for making decisions, which is exactly where we're at now.

Equating the fictive error learning signal of regret here with "greedy remorse" is a bit of a stretch. It assumes that investors are all motivated by excessive desire, or perhaps that all desire is to some extent excessive. There may well have been a remorse that inspired the greedy, but the comment would deny that remorse can also inspire the needy.

The blog and comments raise some interesting points that are worthy of study but, when it comes to bubbles, they are focused on the symptoms and not the cause.

The idea that the Fed is going to manage the economy to prevent "irrational exuberance" and "excessive risk taking" is absurd because the Fed is the central cause of the bubbles in the first place!

As long as the Fed continues to print money, artificially hold down interest rates, and make implicit guarantees to Wall Street (via the "Greenspan/Bernanke put") speculative bubbles will continue to swell and burst.

What I find even more appalling is Bernanke's willingness to make such a statement in the face of the complete failure of the Fed to detect the housing bubble. There are dozens (hundreds?) of clips of Bernanke and company, in the months leading up to the collapse, assuring everyone that the housing market was just fine. Either he and the Fed are incapable of doing what he proposes or he is a liar, both of which are true and either of which clearly indicate he shouldn't be given the power to do what he proposes.

@Sam K: I think you may be taking the point too literally .. I may be wrong but I don't think Lehrer means that the Fed will start scanning people, just that if it did the results would be more conclusive. It's hardly feasible that we scan every single investor out there. Also the whole point is that there's no way you'd have the proof of fictive error learning signals in the majority of investors without the financial signs occuring. The whole point is that those who fall prey to fictive error learning are those who would invest blindly in accordance to the results they believe will occur, which would result in a financial bubble due to the amount of money pouring in.

@RoyNiles: I disagree wholeheartedly. It makes perfect sense to equate fictive error learning of regret to greed. I would argue that Lehrer is not saying all investors have fictive error learning of regret, just most of them. Some are able to exhibit good judgement and risk aversion which enable them to override the fictive error learning process - good judgement of knowing when to stop > regret of possible gain(there's probably some neurological explanation for this but I'm just an English student and therefore more attuned to general social behaviour rather than the explanations behind them. My ignorance of neuroscience is exactly why I find this blog so intriguing to learn from).

A great way the rich insiders gets massively richer is through bubbles

Steady prices do not allow for financial gains like changing prices do, and who do you think owns the biggest percentage just before a crash, the public. That's why they are called the Herd, they stop thinking for themselves and do what everyone else is doing, buy buy buy, it has always been that way.

Greed being what it is will make the public buy when they see a run away money train that is just such a sure thing, while the rich insiders will be offloading onto them, and greed will also make the rich insiders repeat it time and time again.

So Bernanke wants to stop bubbles.... well the rich insiders won't let him take away their golden egg laying goose, so it will never happen, not while there is a shred of greed left in their bones.

To be fair on the public the markets are engineered to look like a sure thing, the rich insiders have had plenty of practice at this engineering and they work every side, including the media, which of course they own.

So what's the next bubble.... carbon credits ?? what ever is it you can count on one thing, it will happen again, and again...... and again.

@Frank: I'm exaggerating to clarify. The neuroscience point makes sense (although I'm certainly no neuroscience expert). My point was that although it is possible that these signals have value that the market has somehow not incorporated, since there's no financial basis for them, they're of little practical use, because as soon as they are used they become effectively useless.

My core objection (and this is not the first time I've made this type of objection) is that Lehrer likes to apply narrow results in neuroscience to make broad financial/market conclusions. I realize that what he says is almost always speculation and simply intended to be thought provoking, but it irks me that the conclusion isn't thought through.

There are too many pop science journalists that do the same thing-- and it's sad that Lehrer seemingly falls into the same trap. Stick to what you know.

Why not just leave it after presenting the admittedly very interesting experiment?

@Sam K: I apologise but I disagree. Lehrer's exact conclusion is that "greedy remorse" and "temporary suspension of loss aversion" are "two essential psychological ingredients of every bubble". This barely seems like a sweeping conclusion on financial/market matters. One can argue till they're blue about market failure, policy failure, regulatory failure etc. Lehrer's merely commenting on "two essential psychological ingredients" which - considering the link between neuroscience and psychology - is a fair comment to arise from a neuroscientific study.

I agree that many pop science journalists make general conclusions, and I agree that there are times when I think Lehrer might be guilty of the same. I'm just saying this isn't one of those times, and that here he has thrown in several valid suggestions to the list of psychological factors that cause financial bubbles.

My main contention with your comment is that Lehrer's suggestion shouldn't be taken as providing some scientific cure. Maybe its because I come from an arts background, but I get frustrated when people become too scientific about the human mind (mind not brain, the difference is there though I would agree that they're deeply entwined).

I'd suggest that instead of trying to derive an experiment from his article from which (admittedly useless) results can be measured, the importance lies in the dissemination of his ideas. If people are made aware of their tendency towards this 'greedy remorse' and 'temporary suspension of loss aversion' they could try and become more self conscience of their motivations and keep themselves in check.

On a small scale, this psychological factor is crucial: e.g, It doesn't take an idiot to see that living in a house that's financed entirely through credit (as some Americans were) is a bit bloody daft really. If these people were able to enact some self restraint it's easy to see that they would not have been affected to the extent that they were.

@Frank: my negative reaction is to the statement:

"One day, it might be possible to diagnose bubbles not by trying to decipher spikes in housing prices, but by sticking people in scanners and studying the intensity of their financial regret."

There's very little after this to suggest he's just disseminating ideas. This is a speculative conclusion coming from a scientist, so to me this sounds like a possible scientific cure.

More importantly, this is the only idea (of his own) that is presented in this blog post, so when you talk about disseminating his ideas, I'm a bit at a loss at finding what other idea could be disseminated.

Thanks for expounding on your background in more detail, though, and I guess this is where we diverge. I personally don't see the point of scientific experiments if not to make conclusions and more falsifiable predictions-- thus increasing knowledge and understanding over time.

@Sam K: I think we're just coming from two completely different ways of looking at things :) Your focus lies on the scientific problems (the uselessness of such an experiment), while I'm more intrigued by his suggestions on psychological motivations of people during a financial bubble. It's pointless to try and figure out what Lehrer was trying to achieve in his post, unless you've found the secret of reading someone's mind (in which case please do share) - I'm far more interested in how it's received, what people take from it (which is why I find my discussion with you intriguing).

Also, I would suggest that anyone writing on the internet automatically disseminates their ideas - its a public forum for discussion. Furthermore, he quotes an entire section from his own book. If writing a book does not equal to an individual attempting to disseminate his ideas I don't know what does :p

I find your other point baffling. It's a bizarre contention against my diction. The plural use of 'ideas' make perfect sense. It's his opinion (there's only one being offered and I'll grant you that) but there's not one simple idea present.