Holy Neurofinancial Meltdown Bernanke
Emotions are riding very high. Herd behavior is everywhere. And if you listen to Treasury Secretary Paulson and Fed Chief Bernanke the primary reason for such a high bailout amount of $700B is to inspire "confidence" in the market. So are our brains to blame for this market mess? Yes, at least according leading neuroeconomist interviewed by Forbes Matthew Herper in his recent piece, Market Mess, Blame Your Brain.
"Fear plus herding equals panic," says Gregory Berns, a neuroeconomist at Emory University. "You bet it's biologically based."At the core of the market mess are securities that were backed by extremely risky mortgages. The theory was that slicing and dicing mortgages diluted the risk away.
But the ratings agencies were being compensated by issuers of the mortgage-backed securities, and neuroeconomics says that created big problems. "You don't get mistakes this big based on stupidity alone," says George Loewenstein of Carnegie Mellon University. "It's when you combine stupidity and people's incentives that you get errors of this magnitude."
Consider this forthcoming research by Loewenstein, Roberto Weber and John Hamman, all of Carnegie Mellon. They organized volunteers into partners. One partner is given $10 and told to split it however he sees fit. On average, the deciding partner keeps $8 and gives away $2.
Then researchers repeat the game. This time, the decider pays an "analyst" to decide how to split the money fairly. The game continues for multiple rounds and the decider can fire the analyst. With this change, the decider gets everything. Paying somebody else to ensure assets are divided fairly actually makes things less fair.
So what's a regulator to do? Read about that in Herper's full article here.