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Neuroscience may help us understand financial bubbles

Five years on from Lehman Brothers' collapse and “where did it all go wrong?” analysis is all the rage. Answers have varied…

A young girl attempts to destroy the world economy. Lynne Cameron/PA

Five years on from Lehman Brothers' collapse and “where did it all go wrong?” analysis is all the rage. Answers have varied: poor regulation, malicious bankers, dozy politicians, greedy homeowners, and so on.

But what if the answer was in our minds? New research published in the journal Neuron suggests that market bubbles are in fact driven by a biological impulse to try to predict how others behave.

Any analysis of the global financial crisis would be incomplete without a thorough understanding of the asset bubble that preceded it. In the run up to 2008, property prices hit dizzying levels, construction boomed and the stock market reached a record high.

Economists have long picked over the causes of bubbles. But researchers at the California Institute of Technology wanted to know whether neuroscience could tell us anything about why so many people kept inflating the bubble to irrational levels.

Benedetto De Martino, now at Royal Holloway University of London, is one of the study’s authors. “For a long time,” he said, “the study of how people actually made decisions was not considered important.”

“It was always assumed people were rational and wanted the best for themselves. But this didn’t match with our observations of how people actually acted in many situations. Now, thanks to advances in neuroscience, we can begin to understand exactly why people behave as they do.”

This new field, known as neuroeconomics, combines traditional economics with insights on how the brain works. To conduct the research, De Martino, a neuroscientist, teamed up with finance professor Peter Bossaerts and Colin Camerer, a behavioural economist. Collaboration between these academic disciplines was key.

The study asked participants to make trades within an experimental bubble environment, where asset prices were higher than underlying values. While making these trades, they were hooked up to scans which detected the flow of blood to certain parts of the brain.

They found two areas of the brain’s frontal cortex were particularly active during bubble markets: the area which processes value judgements, and that which looks at social signals and the motives of other people.

Increased activity in the former suggests that people are more likely to overvalue assets in a bubble. Activity in the latter area shows participants are highly aware of the behaviour of others and are constantly trying to predict their next moves.

“In a bubble situation, people start to see the market as a strategic opponent and shift the brain processes they’re using to make financial decisions,” De Martino said.

“They start trying to imagine how the other traders will behave and this leads them to modify their judgement of how valuable the asset is. They become less driven by explicit information, like actual prices, and more focused on how they imagine the market will change.”

“These brain processes have evolved to help us get along better in social situations and are usually advantageous. But we’ve shown that when we use them within a complex modern system, like financial markets, they can result in unproductive behaviour that drives a cycle of boom and bust.”

But not everyone agrees with the findings of this study. Richard Taffler from Warwick Business School points out that bubble markets exist in a social context that is difficult to replicate in a lab experiment.

“In the real world there are lots of actors - investors, the media, pundits, politicians - all unconsciously colluding together to create a desired reality,” he said.

In the case of asset pricing bubbles such as the property market in the last decade, or the dotcom boom of the late 90s, everyone has a vested interest in maintaining this unconscious fantasy.

For Taffler, understanding how the brain processes these decisions is useful but still, “a few stages removed from the reality of a real market environment in the middle of an asset pricing bubble.”

“‘Mania’ is a more useful word for this phenomenon than ‘bubble’ as it implies manic behaviour, with people getting carried away.”

But this research is just the beginning, and it is clear that the overlap between neuroscience and economics will yield some important insights into human behaviour. As De Martino points out, markets are made by people, not numbers, and the human brain has been around for far longer than any financial market. To understand the market, we must understand the brain.

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37 Comments sorted by

  1. Mark Lawson

    senior journalist at Australian Financial Review

    Having gone through a couple of bubbles myself I'm with Taffler.. I doubt whether any neuro experiment could shed much light on what remains a fantasy environment when even experienced, educated, highly-intelligent traders lose all touch with reality. In any case, I suspect its not just one response. There are the amateurs who keep inflating because, for the first time in their lives, they've got some real money.. then there are the old hands who know perfectly well its all nonsense but intend to get out before the bust, and the players who genuinely forget or who start believing their own hype and get caught. I doubt that its one, simple neuro-response..

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  2. Peter Ormonde
    Peter Ormonde is a Friend of The Conversation.

    Farmer

    Excellent - we should be strapping up these pimply screen jockeys to fMRI gadgets and alarm systems... were it so easy.

    I don't think it's rocket science Michael - it's greed pure and simple ... a feeding frenzy of inevitable returns, sure things, the ever rising escalator ... bigger higher taller ... until the morning it isn't.

    Greed coupled with ignorance is particularly effective. Your old hands are smart enough to get out just before the music stops and they manage to flick their overvalued…

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  3. Michael Sheehan

    Geographer at Analyst

    I'm not sure that middle-aged academics earning less than a pimply 22 year old Investment Banking graduate have got much to offer on this topic.

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    1. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      Peter, you better not apply to any of these finance firms. Their graduate trainees have to go through very rigid critical reasoning tests before they even get an interview. Having insight into that world would be necessary, but not sufficient. I'd say that Gina and Clive would be useless, but I'd bet Rupert's input would improve this research immensely.

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    2. Peter Ormonde
      Peter Ormonde is a Friend of The Conversation.

      Farmer

      In reply to Michael Sheehan

      OK Mike ... let's start doing some geography seeing as you've obviously got little grasp of economics or the workings of a currency desk. Something I've done a fair bit of over the years.

      What sort of geography do you like ... urban, social, physical ... let's start chatting about something you might know something about. The names of some of you more inspirational mentors would do .. well go from there.

      But in reference to your first point - if you will dismiss the work of academics on the basis of their incomes, then Gina and Clive would be right at the top of your heap of economic analysis.

      I'm increasingly convinced that you are a fraud. I can't find any Michael Sheehans in any connections with geography - nothing about 'Analyst' whatever that is... not even a graduation record - at least not in Orstaya or New Zealand.

      So let's rock... strut your stuff.

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    3. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      The most significant influences start with Herodotus, Strabo, Euclid, and Ptolemy. Later on Humboldt, Christaller, von Thunen, Sauer, Coase, Harvey, Castells, Soja, Clark, Krugman, Swyngedouw, Diamond, and some folks in the GIS space. But that's not enough for here.
      But mate, if you are looking for insight into the GFC, you need yourself a compass, as the currency desk is way off course. You need to hook up with some old prop traders. and product development folks, and other quants.

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    4. Peter Ormonde
      Peter Ormonde is a Friend of The Conversation.

      Farmer

      In reply to Michael Sheehan

      Can't see any economists in there 'Mr Sheehan' ... doesn't seem to limit your insights though.

      I'm assuming Diamond is Jared... excellent. I like him. I shall tool up over the weekend.

      Currency desks are in fact the agent of transmission in a globalised financial system - the vector of contagion if you like ... what turns a sneeze on Wall street into the terminal gasping of your Iceland, Greece, Spain, Italy and Cyprus overnight. But you'd know that of course. The most mobile and speculative…

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    5. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      If you can't see any economists in that list, you've never studied economics. Be that as it may, you didn't ask for economists.

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    6. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      You say my list of a dozen or so is copied in alphabetical order straight from a dictionary of thousands of entries? Hmmmm...not the English alphabet.
      And if you think prop traders and product development folks are "ac countants" you've never been a trading floor. They are more likely to be Physics/Engineering/Statistics PhDs.

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    7. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      If you are still stuck on the economists, two of those listed have Nobel Prizes. ;)

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    8. Peter Ormonde
      Peter Ormonde is a Friend of The Conversation.

      Farmer

      In reply to Michael Sheehan

      Not really 'Mr S' ... most of the screen jockeys I knew were drop-outs actually ... some had a smattering of economics, some accounting and commerce/law type stuff ... couple of maths whizzes who went on to run successful bookie operations even a half finished MBA .

      But it's interesting to note that in your list of likely traders there is - yet again - no mention of economics or the more human sciences... not that it would help given the parlous state of such thinking and the essentially menial functions that such folks perform.

      Product developers are not the same as traders 'Mr S' nor are they found in the same environment ...

      Please stop demonstrating your flailing ignorance of such matters and stick with your Euclid and classical Greece - an area in which your comments have weight and interest. Stop pretending Mike.

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    9. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      Peter, you didn't ask for a list of folks in the financial trading, or economics space, but GEOGRAPHY.

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    10. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      "most of the screen jockeys I knew were drop-outs actually..."
      Somehow I doubt they were Vice Presidents and above at Lehman Brothers, Goldman Sachs, or JP Morgan in 2008.

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    11. Peter Ormonde
      Peter Ormonde is a Friend of The Conversation.

      Farmer

      In reply to Michael Sheehan

      You reckon those VPs and above were screen jockeys at some point in their careers 'Mike'? ... possible, even plausible but rather unlikely.

      And in fact I asked you for your 'inspirational mentors' - hoping that a polymath like yourself might have actually read the odd economist or even economic geographer ... apparently not. Here you go ... bone up: http://joeg.oxfordjournals.org/

      Stop pretending 'Mike' ... might work with the ladies down at the RSL on pension night, but not here.

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    12. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      Peter, as I said, I listed two Nobel Prize winners in Economics above.

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    13. Michael Sheehan

      Geographer at Analyst

      In reply to Michael Sheehan

      And about TEN economic geographers.

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    14. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      I'll leave you to your frantic googling and Wikipedia trying to catch up. Save your breath, you haven't gott enough time.

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    15. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      "You reckon those VPs and above were screen jockeys at some point in their careers 'Mike'?"
      Peter, the relevant desks - prop trading, structured products, MBS, are full of VPs and MDs.

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    16. Peter Ormonde
      Peter Ormonde is a Friend of The Conversation.

      Farmer

      In reply to Michael Sheehan

      I can see no evidence of any economic literacy here 'Mr Sheehan' ... tell us what you learned from any one of the Nobel winners you have listed and why you agree with it.

      I don't use google - I don't trust it... and worse it just churns out the same stuff that everyone else finds using the stultifying criterion of popularity. Produces a very pedestrian form of plagiarism.

      I use a meta search engine - Mamma - the mother of all search engines http://www.mamma.com/ ... groups 34 different services…

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    17. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      Sources of WHAT? Things I've read? People I've been taught by? Jobs I've had, Me thinks, it's your turn to contribute something, apart from just being wrong every time you post.

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    18. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      "By Monday we'll be able to have a chat about his interesting looking work in a bit of depth."
      No we won't. I'm not interested in blog tutoring.

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    19. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      "Produces a very pedestrian form of plagiarism."
      An accusation against me you will now be withdrawing, yes?

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    20. Peter Ormonde
      Peter Ormonde is a Friend of The Conversation.

      Farmer

      In reply to Michael Sheehan

      Of this: 'Peter, the relevant desks - prop trading, structured products, MBS, are full of VPs and MDs.'

      When I did some work for the Australian Bankers Association a few decades back ... all the senior execs seemed to do was have long tax subsidised lunches.

      So I'd be most interested to see that we now find senior finance executives engaging in the cut and thrust of a frenzied trading floor ... knock yourself out.

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    21. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      Peter, the Australian Bankers Association has about as much relevance to trading on Wall Street and in the City in 2008, as landing on the moon had to do with the CWA.

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    22. Peter Ormonde
      Peter Ormonde is a Friend of The Conversation.

      Farmer

      In reply to Michael Sheehan

      Answer the question Mike ... on what basis do you assert that 'Peter, the relevant desks - prop trading, structured products, MBS, are full of VPs and MDs.'

      All I'm pointing out with my limited and dusty knowledge of the working habits of finance execs in Australia during the 1990s is that the main OH&S hazard was overeating rather than over-excitement.

      I am asking you to enlighten me regarding this new-found work ethic and their undoubtedly valuable presence on the trading floors of the world's markets .. with sources rather then the usual ungrounded assertion.

      Not difficult to a fella with your obvious expertise in such matters.

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    23. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      Peter, you're not showing much good faith here. You ask a question, which I have answered in detail. But when you reply, there is not "thanks", or "how interesting", but abuse for not providing a reply to a question you've never asked before.

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    24. Peter Ormonde
      Peter Ormonde is a Friend of The Conversation.

      Farmer

      In reply to Michael Sheehan

      Good faith!!! Good grief ... I roll about on the floor howling in uproar ... that's RAOFLHU to you tweeters...

      I've demonstrated considerable good faith over recent weeks 'Mr Sheehan' attemp[ting to discuss your posts as though they presented a considered view from a legit commenter. But it's not true, is it?

      Not a geographer, not even 'Michael Sheehan', a bogus list of purported intellectual mentors clipped from a website, no evidence of any study or interest beyond classical greece - which is fine, incidentally if you stuck to that or at least bothered to research your 'deeply held opinions' ... in the absence of that interest, and in the presence of such pretence, ' Mick', you're just a heckler.

      My good faith, patience and interest is exhausted. I shall no longer engage your strange enthusiasm. I would suggest serious folks with any real interest in these issues do likewise. There is nothing to respond to ... just noise.

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    25. Michael Sheehan

      Geographer at Analyst

      In reply to Peter Ormonde

      Peter, you have failed now 3 times to show I picked my mentors "clipped from a website". You had no idea who just about every one of them was. You couldn't even see the Nobel Prize winning Economists. And still have not worked out there are about ten economic geographers. Peter, me thinks your faux outrage is a pretty limp-wristed way of just admitting you are way out of your depth. And even more so the GFC. Currency desk? ROFL. ABA CWA? ROFL.

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  4. Robert Tony Brklje
    Robert Tony Brklje is a Friend of The Conversation.

    retired

    All people are not the same, there are many physical characteristic that that differ, one of those physical characteristics is the brain.
    Some amongst us are psychopaths who will ruthlessly exploit any circumstance for personal advantage regardless of outcome for the group. They will collude together to gain maximum advantage, with their goals being egoistic gain and lust fulfilment.
    Those types of conspiracy always take time, seeking to further exploit the situation and gaining greater numbers…

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  5. James Hill

    Industrial Designer

    It could be a simple case of game theory.
    Take a set number of people with equal of money all bidding for a single item.
    Guess the final price.
    It may not be what a single person may bid if they borrow someone else's cash to but the item on a promise of paying something more in repayment.
    So the asset inflation is inevitably linked to some sort of lending practice, which might account for the Mosaic injunction against usury, some twenty three centuries old.
    Why do people hate history?
    Does it spoil the fun?
    The joyous fun of re-discovering the same errors in every generation?

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    1. James Hill

      Industrial Designer

      In reply to James Hill

      No, put that usury "regulation" at thirty three centuries ago.
      Never a lesson to be learned from history.
      And Adam Smith, who put the "historical method" into economics?
      Adam who?
      If greed is part of neuroscience then neuroscience is pretty old.

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  6. Jon Brock

    ARC Australian Research Fellow in Cognitive Science at Macquarie University

    There's no denying it's a very cleverly designed study. It tells us something about the brain regions involved in financial decision making. But the underlying logic of inferring what people are thinking from which bits of their brain are active is deeply problematic.

    The authors focus on the dorso-medial prefrontal cortex which is indeed involved in making social judgements. But it's also involved in a heap of other things.

    The brain coordinates given in the paper are (9, 50, 28). Plug that…

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    1. Jon Brock

      ARC Australian Research Fellow in Cognitive Science at Macquarie University

      In reply to Jon Brock

      This, from a recent critique in the Journal of Economic Methodology:

      "The considerations made above suggest that neuro-mental correspondences reported by neuroeconomists are unlikely to have an evidentiary function because of logical flaws and/or difficulties in identifying the exact role played by the cerebral structures. They may have a heuristic function: they can point to the presence of specific differences between phenomena considered homogeneous or to the existence of a relationship between two mental activities, but these specificities and relationships must be established at the psychological level."

      http://www.antonietti.psycholab.net/documenti/dm%20neuroeconomics.pdf

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  7. Michael Sheehan

    Geographer at Analyst

    The problem with study's methodology is that it did not replicate the market structure in 2998. These CDOs were private-labeled, and thus never traded over public exchanges. They were all over-the-counter negotiated individually between IN and investor, with the IB setting up special purpose entity/vehicle (SPV). So this study's tracking. In other words there was no market price to, let "underlying value".
    The GFC was an asymmetry event on two level: One, informationally. Investors were cheated on what mortgages made up those CDOs; the other was cognitive.

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    1. Michael Sheehan

      Geographer at Analyst

      In reply to Michael Sheehan

      Sorry, market structure in 2008, of course.

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