Of brains and economic crises
We wrote in The Wall Street Journal’s Mint about how it is not bad financial decisions that lead to an economic crisis, but actually biological origins of human behaviour, including deviant economic behaviour that leads to financial crises.
You can read the article on LiveMint here.
For those who would like to save a click, here is the entire article. ————————
Will another financial crisis, worse than the present one, hit the world economy? As governments around the world grapple with the present crisis, the question might seem absurd.
From the Mexican crisis to the Asian financial crisis to the dot-com bubble to the present crisis, the scale has only grown. The solace being that although crises have become deeper, the apparent economic reason for each crisis is different. But the next crisis, when it happens, will be of an even wider global scale. Even though there might be short-term attempts at protectionism and shoring up individual national economies at the cost of global trade, in the long run the winds of globalization will blow stronger across even more countries than today. So even as we tackle this present crisis, we need to take far more constructive steps to predict and better manage the next one.
Help is at hand. Thanks to developments in neurology, and more so in cognitive neurology, we now have a fundamental science to understand the biological origins of human behaviour, including deviant economic behaviour that leads to financial crises.
Why have so many intelligent people, who had access to quality information to make the right decisions, make horrific mistakes? Blame it on the human brain. The brain at every moment is inundated with stimuli and it is impossible to do an elaborate processing of it all. So many a time the human brain uses cognitive short cuts called heuristics to arrive at decisions. The huge impact of heuristics in all human decisions has been studied in detail by Daniel Kahneman the winner of the Nobel Prize for economics in 2002 and Amos Tversky, a pioneer of cognitive science.
Other than clinically depressed people, all human beings are “overconfident” of their abilities. Thanks to this overconfidence, they are unable to predict the full consequences of negative events, especially when the probability of that event is very remote. No wonder, even as some of the leading independent brokerage firms were changing their status to bank holding companies to strengthen their capital base, some leading private equity firms that were not affected by the present crisis were making plans to become independent brokerage firms. Clearly, the human brain is overconfident even at the time of a crisis.
Why did so many leading investment firms that were smart enough to avoid the present crisis fall prey to the guile of Bernard Madoff? When we are stuck in a traffic jam and we a see a car or two ahead turning left into a lane, we too will turn into that lane though we don’t know where that lane leads. Thanks to social proof heuristics, in an uncertain situation it is hardwired in our brains to look around to see what others are doing and blindly follow what they do. Many an intelligent investment manager, while looking out of the window, saw several other investment managers queuing up outside Madoff’s office and getting handsome returns.
Madoff played another trick on the brain of his potential investors. He made it tough for any investor to initially invest in the fund. You had to be invited or recommended by an existing investor. As Madoff made investing in his fund seemingly “tougher”, the demand for his funds grew. The brain is hardwired to believe that anything scarce is more valuable.
The heuristic principles hardwired into the human brain will sow the seeds of the next financial crisis on a regular basis. It is inevitable. Instead of seeing this as an economic aberration, it is best to treat it as a behavioural problem. It is high time we have more behavioural economists and cognitive neurologists in key positions among regulators and in companies to better predict and explain fundamental human behaviour and nip these behavioural irregularities in the bud.