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Between Euphoria and Fear

Has traditional microeconomics ignored the mood swings that drive financial crises?

Janice Gross Stein

In the wake of last year’s financial crisis, Alan Greenspan, former chair of the United States Federal Reserve, expressed astonishment at the irrational behaviour of institutional leaders. “Those of us who looked to the self-interest of lending institutions to protect shareholders’ equity—myself especially—are in a state of shocked disbelief.” A strong believer in the rationality of decision making, Greenspan was shocked by the myopic behaviour of bankers who exposed their institutions to large risk for short-term gain.

He is not alone in his confusion. Looking back, we cannot seem to make up our minds about what went wrong. For some, such as Greenspan, it is individual decision making that was “irrational.” For others, such as Joseph Heath in his September essay for this publication, it is individually rational, self-interested decisions that resulted in collectively poor outcomes. These two diagnoses are quite different. In fact, they contradict one another.

Those who blame irrational investors point to the behaviour of many who, after the stock market began to drop in 2008, seemed to make a bad situation worse by selling their shares and mutual funds. As a group, they would have lost much less money had they simply held onto whatever funds they owned. This kind of “irrational” reaction is quite common. An analysis of investor behaviour in all U.S. equity funds from 1991 through 2004 by Geoffrey Friesen and Travis Sapp, for example, found that fund holders consistently bought high and sold low except during long secular bull markets.

That people frequently do not behave like rational investors is not trivial. Financial decision making should be a relatively easy example of rational choice. It is reasonable to expect consumers to balance carefully the likely costs and benefits in the decisions they make on large issues that matter to them, such as saving for retirement and mortgages. On these kinds of issues, measurement is not difficult, and we can estimate the probabilities with reasonable confidence. If the rational choice models that economists so love are a poor predictor here, then they are unlikely to be good predictors anywhere.

Many economists disagree. Even if individuals do not behave rationally in the financial marketplace, they argue, collectively we still get optimal outcomes. How can this work?

Investors generally do not pay a great deal of attention to trends over long periods of time.

Experts in this camp would say that although some consumers are irrational—seduced by clever advertising, overly optimistic in their expectations or short-sighted in their time horizons—their random “noise” is cancelled out either by the large numbers who do make rational choices or by those whose choices err in the opposite direction. As long as the numbers are large enough, we can safely ignore those people who buy subprime mortgages in the expectation that housing prices will continue to rise indefinitely.

Recent evidence has made such optimism impossible to defend. For the argument to work, the errors must be random. Evidence from psychology tells us these errors are not random but systematic. We know, for example, that people generally get far more upset about losses they suffer than they get pleasure from comparable gains that they make. Investors who sold out of the equities markets during the fall of 2008, in the middle of the market crash, and then sat on the sidelines, were likely to celebrate the fact that they had avoided later losses that season, ignoring the gains they likely missed when markets rallied this past spring and summer. Here, individual irrationality is far more than random noise that is washed out in an efficient marketplace. On the contrary, these decisions create large “irrational” swings in financial markets.

Well and good, Joseph Heath argued in these pages two months ago, but there is a fundamental asymmetry between rationality and irrationality, even when irrationality is systematic, patterned and predictable. Irrationality, he explains, creates a buying opportunity for the rational whereas rationality does not create a comparable buying opportunity for the irrational. Smart investors systematically go into the markets when loss-avoiders are fleeing, buying equities far more cheaply than they otherwise could. Once enough rational buyers understand the pattern and buck the trend, they change the direction of the trend. Over time, says Heath, rationality drives out irrationality.

Unfortunately, the evidence does not support this attractive logic either. Those who study what people actually do—rather than what they should do—have demonstrated that investors generally do not pay a great deal of attention to trends over long periods of time, even on important issues such as investment for retirement. That is why governments cannot depend on markets alone to drive out irrationality, certainly not in the short term and often not in the long term, and instead must intervene to help produce socially desirable outcomes.

In the new language of neuro-economics, emotions are the carriers of utility.

A second argument about the relationship between individual choices and collective outcomes reverses the logic we have just examined. It insists that people are indeed rational in their financial decision making, but that their individually rational choices produce collectively poor outcomes. It is this paradox that explains the well-known “tragedy of the commons.” The incomes of investment managers, for example, depend on relative, not absolute, performance. In the last decade, these managers created complex securities that had serious but well-camouflaged risks, which sold well with good profit margins. But when all managers took such risks, they became mutually offsetting. In the long run, no one benefited. The absolute performance of individual managers did not improve and the risk of financial crisis rose sharply. It is these kinds of conflicts between individual and group interest that create the necessity for regulation.

Which assumption political leaders make—are we rational or irrational?—matters to the kind of regulatory regime they design. If individuals are rational, then light regulation in efficient markets will do most of what needs to be done. We need to pay attention only to those cases where individual rationality produces collectively bad outcomes. If, however, we do not behave as microeconomic models of rationality suggest, and if our errors are not random but systematic, then preventing the next financial crisis is much harder.

To complicate matters further, pioneering new research in neuroscience in the last 15 years by Antonio Damasio and Joseph LeDoux, among others, demonstrates that emotion is primary and plays a dominant role in choice because it is automatic and fast. Damasio was able to observe closely patients who had suffered injury to those parts of the brain that process emotions, and, to his surprise, his patients were unable to make even simple rational choices even though their cognitive systems were fully intact. Rationality, he demonstrated in his clinical research, requires emotion. Damasio’s work sparked a new field of research, helped by functional MRIs that now allow scientists to “see” people feeling and thinking. The new evidence suggests that emotion operates largely below the threshold of conscious awareness and, contrary to conventional wisdom, people generally feel before they think and—what is even more surprising—often act before they think. The conscious brain then interprets behaviour that emerges from automatic, emotional processes as the outcome of cognitive deliberations.

Emotions are adaptive programs of action. They address the go/no-go questions, while cognitive processes answer true/false questions. Behavioural economists, who study how people actually make financial decisions, have drawn on this new research in neuroscience to challenge the dominant economic model of decision making. In the new language of neuro-economics, it is emotions that are the carriers of utility—that tell us what we value, what is important to us.

Mainstream economics treats risk as judgement informed by probability theory. Psychologists see it differently.

Fear, one of the basic emotions, is powerful. The sharp sell-off in global markets in the last quarter of 2008 is probably best understood as a fear reaction that expressed itself in flight. The flight took place despite entreaties by financial advisors not 
to sell and therefore lock in losses that would 
not be regained when investors missed the market rally that would inevitably come. As we noted earlier, investors responded not by calculating likelihoods but with a swift, sharp and frightened response. While financial columnists bemoaned their stupidity, people fled the markets. Even as such widely respected authorities as Warren Buffett spoke out to reassure investors and urged them to treat the downturn as a buying opportunity, fearful investors continued to sell their assets. “We are caught in a spiral in which we are so scared of losing our jobs, our savings, that fear overtakes our brains,” moaned neuroscientist Gregory Berns. A recent survey of American households by McKinsey found that 90 percent were spending less than they had before the recession. More than half were doing so by choice, rather than out of need. And a majority said they would continue to spend less even when the economy recovered.

An important element in financial choices is people’s perception of risk and their willingness to take risk. Mainstream economics treats risk as judgements about variation over outcomes, judgements that are informed by probability theory. Psychologists see it differently. The propensity to take risk is in part determined by whether people have gained or lost in relation to some reference point. After the sharp drop in the markets in September 2008, people focused on what they had before the markets dropped; they thought they were in the domain of loss. In November 2009, some still think they are in the domain of loss if they use as their reference point what they had before the 
sharp drop of last year. Others think they are in 
the domain of gains if they use the market low of March 2009 as their reference. People who perceive themselves to be in the domain of loss are more willing to take risks (to recover their losses) while people who see themselves in the domain of gain are risk averse (in order to conserve what they have). Such behaviour is an example of the asymmetry of feelings that explains loss aversion. I am far more upset if I lose my wallet with $100 than 
I am happy if I find $100 on the street.

In Nudge: Improving Decisions about Health, Wealth and Happiness, Cass Sunstein and Richard Thaler trace the impact of emotion in financial behaviour over time. Why, they ask, do so many of us fail to put aside the financial resources 
we need for retirement? Why do we not know what we 
need to save in order to avoid a significant loss of income after we retire? The most compelling explanation for this illogical behaviour is that most people feel the urge to satisfy their immediate needs, but they only think about satisfying their future needs. Emotion trumps thinking in part because, even though we can think about the future, we are not very good at imagining how we will feel when we get there.

As investors flee to safety, they trigger the financial crisis they feared most.

There is a catch here: what we know about the impact of emotion on decision making is necessarily drawn from studies of individuals. George Akerlof and Robert Shiller, in their analysis of the animal spirits that John Maynard Keynes first wrote about, have extended the argument from individual to collective outcomes. In both asset bubbles and panic selling, they argue in Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, individual choices converge, with major collective consequences. Even Alan Greenspan, one of the leading proponents of rational choice and efficient markets, in an interview in the Financial Times, acknowledged the presence of “innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve.”

Epidemiological and viral models help to explain the spread of emotion from an individual to a larger group. Confidence is an emotional state, a reflection of my optimism about and trust in the future. But it depends as well on thinking: do I think that other people share my optimism about and trust in the future? When an individual’s mood is partly a function of the mood of others, it is as reasonable to speak of a collective mood as it is to speak of shared norms. Economists now routinely use measures of “public” confidence in the future of the economy as a leading indicator of economic growth.

Asset bubbles and panic selling are both products of this kind of collective emotional state. Confident investors buy homes or stocks—or tulips—when the price is increasing, in the expectation that it will continue to rise. Other investors, seeing the price rise, begin to buy as well in the expectation that it will go higher. If such self-reinforcing and amplifying loops, which economists call price-to-price feedback, continue unchecked, a price bubble develops through a process that Robert Shiller called “irrational exuberance.” As the bubble in housing prices grew in the United States in the last decade, for example, people consumed more and saved less in part because they had, or thought they had, an asset that was growing in value. They counted the value of their homes as part of their savings. The increase in home prices fuelled public confidence and generated a “price to emotion to price” loop that fed into the real economy.

Eventually, of course, bubbles burst. Selling after a bubble bursts also has a large emotional component embedded in the same kind of amplifying feedback loop. Panic selling is a mood swing, but it is more than a mood swing; the change in emotional state is connected through feedback loops to the real economy. A sharp drop in housing prices, for example, means some mortgagees cannot pay their debts, which in turn hurts lenders who suddenly need to increase their capital ratios to cover losses. As lending falls, consumers’ confidence decreases, which reduces spending, corporate profits and stock prices. Falling consumer confidence stokes fear and fear fuels uncertainty, which in turn reinforces diffuse fears about unspecified possible economic collapse. As investors flee to safety, they trigger the financial crisis they feared most. Over and over in economic history, in cycles, exuberance is followed by panic.

Why did so many economists and policy makers fail to foresee the Great Recession? In large part because their models assume rational choice and ignore the human dynamics—fear and greed—that shape economic crises. We dismiss human nature in all its complexities at our peril. Beneath a thin veneer of microeconomic rationality, powerful emotional dynamics first created individual confidence that spiralled into collective euphoria, and then—after the bubbles inevitably burst—individual fear that diffused into shared panic. None of this should come as a surprise. These emotional and cognitive patterns reflect who we are. This is how we reason.

Tough regulation might be able to blunt the edges of asset bubbles and panic selling, but it cannot prevent them.

This story of emotion and reason has provocative implications. First, we know a lot less than we think we do. The criteria for microeconomic rationality are far less obvious than most economic models have assumed. It is not clear, for example, despite the almost rote repetition by financial analysts, that a “buy and hold” strategy for equities maximizes gain; much depends on when the comparison starts. At the end of December 1964, the Dow Jones industrial average was at 874; at the end of December 1981, 17 years later, it was one point higher. If there are 20-year periods of low or no gains in the stock markets, then those middle-aged people who sold early in this recession are not obviously irrational. Their behaviour only looks puzzling against the received wisdom of economists. Perhaps it is time for far more modesty and far less certainty on the part of those who model financial choices.

Second, the contradictions between short-term individual self-interest, longer-term self-interest and the collective good run throughout this story. The tragedy of the commons was enacted again and again, both before and during this last recession. Traditionally, we have tried to address these tensions through government regulation and at times we have succeeded. But much more rigorous macro-prudential regulation, as well as new instruments to manage the failure of very large and well-connected financial institutions in a global economy, are now needed. The prospects for such measures are not encouraging; and even if they were, tough regulation might be able to blunt the edges of asset bubbles and panic selling, but it cannot prevent them.

When asked whether another recession like the one we have just lived through can be prevented in the future, Federal Reserve chair Ben Bernanke answered with an unequivocal and honest no. There have been recessions throughout recorded economic history and it is futile, he argued, to think that we can prevent them. They are created by who we are—emotional as well as thinking beings. But there is an opportunity for reflection, for learning and for control of our emotions. He was asked why he had bailed out the large financial institutions that were teetering on the edge of bankruptcy. His answer is instructive:

I was not going to be the Federal Reserve chairman who presided over the second Great Depression. For that reason, I had to hold my nose and stop these firms from failing. I am as disgusted about it as you are.

Uncontrolled, his disgust would have led Bernanke to let the big institutions fail and allow the market to do its work. But he held his nose, controlled his emotions and did what he thought he needed to do. Only time and historians will tell us whether Bernanke and his colleagues succeeded in preventing an economic and social catastrophe. If so, then the capacity for analysis, learning and self-control—as much a part of who we are as our instincts, emotions, mood swings and feelings—made a significant contribution to the welfare of 
us all.

Janice Gross Stein is Belzberg Professor of Conflict Management and the director of the Munk Centre for International Studies at Trinity College in the University of Toronto.