Can Neuroeconomics Explain Booms and Busts?

By Mark R Stephens 

Applying the findings of neuroscience to economics has provided us with a new addition to the dictionary: “neuroeconomics.”

Nowadays a wealth of studies examine brain activity to helps us understand how we make decisions and translate that into behaviour, in all walks of life. When we apply this to economics it can lead to insightful observations about the business decisions we make, like when buying and trading.

imag17

 

One big question in this respect is: how self-made are the booms and busts we have witnessed in recent times?

What is Neuroeconomics?

Neuroeconomics is concerned with human decision making and how this affects and guides models of economics.

It combines several areas of research: as well as neuroscience, experimental and behavioural economics, cognitive and social psychology, theoretical biology, computer science, and mathematics have all contributed to this field.

Although it is new, it takes a similar approach to “behavioural economics” in as much as it considers social, cognitive, and emotional factors in understanding the economic decisions we make; the neuroscientific element also integrates neural mechanisms into our understanding of economic behaviour.

Bubbles and Pops

Everyone reading this will have lived through a recent “bust”- the dotcom crash, the Global Financial Crisis of 2008 etc. Many theories have been put forward about what caused the latter, from poor regulation through to controlling, manipulative bankers and incompetent governments.

It’s all well and good examining the economic and legislative reasons why it happened, but all along the line, real people at the front line made real decisions that had real consequences: very harsh consequences if you were on the staff at Lehmann Brothers, and lost your job overnight.

What was going on in the trader’s minds?

A recent study at the California Institute of Technology, and published in the journal Neuron, suggests that it is a biological impulse to predict how others behave – and that this helps to drive the “bubbles” that lead to the big “pops”.

Thus, the asset bubble that preceded the GFC drove the stock market to record highs; everyone knows that bubbles have their limits and always end up popping if they reach these limits – so what made everyone keep blowing and making the bubble bigger?

Perhaps nobody expected it to burst in their own face, and that was part of the reason. The study authors were interested in this behaviour that seemed to be irrational and driven by almost manic characteristics.

Study Findings

The study ran tests on participants who were asked to make trades within a staged “bubble” trading environment; it found that the two areas of the brain most active during this process were those that control value judgements and that look at social signals and the motives of other people.

So, as well as overvaluing assets in a bubble, participants showed that they were highly aware of the behaviour of others and were trying to predict the judgments of fellow “traders”.

imag18

Consequently, rather than making dispassionate decisions based on explicit information, like actual prices and value, they were more focused on predicting how the market will change from others’ behaviour. It was described by one of the study leaders as a “group illusion”, with traders believing that there were others in the market who knew better than them. This resulted in poor investment decisions.

At the heart of behavioural economics is the notion that our decisions are not always based upon logic and sound reasoning, but are often made when our judgement is impaired and influenced by others: sometimes a useful characteristic is social situations, helping us to form more tolerant and closer relationships, but not the best trait for making clear financial decisions.

FREE eBook Gift for Signing Up
Get Your FREE eBook

Subscribe to Robert's mailing list and get a FREE eBook offer.

FREE eBook Gift for Signing Up
Get Your FREE eBook

Subscribe to Robert's mailing list and get a FREE eBook offer.