THE EASTER BUNNY, BIG FOOT AND HOMO ECONOMICUS WALK INTO A BAR...:

The Science of Economic Bubbles and Busts: The worst economic crisis since the Great Depression has prompted a reassessment of how financial markets work and how people make decisions about money (Gary Stix, June 22, 2009, Scientific American)

The behavioral ideas now garnering increased attention take exception to some central ideas of modern economic theory, including the view that each buyer and seller constitute an exemplar of Homo economicus, a purely rational being motivated by self-interest. “Under all conditions, man in classical economics is an automaton capable of objective reasoning,” writes financial historian Peter Bernstein.

Another central tenet of the rationalist credo is the efficient-market hypothesis, which holds that all past and current information about a good is reflected in its price—the market reaches an equilibrium point between buyers and sellers at just the “right” price. The only thing that can upset this balance between supply and demand is an outside shock, such as unanticipated price setting by an oil cartel. In this way, the dynamics of the financial system remain in balance. Classical theory dictates that the internal dynamics of the market cannot lead to a feedback cycle in which one price increase begets another, creating a bubble and a later reversal of the cycle that fosters a crippling destabilization of the economy.

A strict interpretation of the efficient-market hypothesis would imply that the risks of a bubble bursting would be reflected in existing market prices—the price of homes and of the risky (subprime) mortgages that were packaged into what are now dubbed “toxic securities.” But if that were so and markets were so efficient, how could prices fall so precipitously? Astonishment about the failure of conventional theory was even expressed by former chair of the Federal Reserve Board Alan Greenspan. A persistent cheerleader for the notion of efficient markets, he told a congressional committee in October 2008: “Those of us who looked to the self-interest of lending institutions to protect shareholder’s equity, myself especially, are in a state of shocked disbelief.”

The behavioral economists who are trying to pinpoint the psychological factors that lead to bubbles and severe market disequilibrium are the intellectual heirs of psychologists Amos Tversky and Daniel Kahneman, who began studies in the 1970s that challenged the notion of financial actors as rational robots. Kahneman won the Nobel Prize in Economics in 2002 for this work; Tversky would have assuredly won as well if he were still alive. Their pioneering work addressed money illusion and other psychological foibles, such as our tendency to feel sadder about losing, say, $1,000 than feeling happy about gaining that same amount.

A unifying theme of behavioral economics is the often irrational psychological impulses that underlie financial bubbles and the severe downturns that follow. Shiller, a leader in the field, cites “animal spirits”—a phrase originally used by economist John Maynard Keynes—as an explanation. The business cycle, the normal ebbs and peaks of economic activity, depends on a basic sense of trust for both business and consumers to engage one another every day in routine economic dealings. The basis for trust, however, is not always built on rational assessments. Animal spirits—the gut feeling that, yes, this is the time to buy a house or that sleeper stock—drive people to overconfidence and rash decision making during a boom. These feelings can quickly transmute into panic as anxiety rises and the market heads in the other direction. Emotion-driven decision making complements cognitive biases—money illusion’s failure to account for inflation, for instance—that lead to poor investment logic.

The importance of both emotion and cognitive biases in explaining the global crisis can be witnessed throughout the concatenation of events that, over the past 10 years, left the financial system teetering. Animal spirits propelled Internet stocks to indefensible heights during the dot-com boom and drove their values earthward just a few years later. They were present again when reckless lenders took advantage of low-interest rates to proffer adjustable-rate mortgages on risky, subprime borrowers. A phenomenon like money illusion prevailed: the borrowers of these mortgages failed to calculate what would happen if interest rates rose, which is exactly what happened during the middle of the decade, causing massive numbers of foreclosures and defaults. Securitized mortgages, debt from hundreds to thousands of homeowners packaged by banks into securities and then sold to others, lost most of their value. Banks witnessed their lending capital decline. Credit, the lifeblood of capitalism, vanished, bringing on a global crisis.