This Is Your Brain on Prosperity: Andrew Lo on Fear, Greed, and Crisis Management

INSERT DESCRIPTIONAndrew Lo


Andrew W. Lo
is the Harris & Harris Group Professor at M.I.T. and director of its Laboratory for Financial Engineering. (Here are some of his papers.)

To my mind, he’s one of the most fluent guides to the state of modern finance in that he combines the rigors of a quant with a behavioralist’s appreciation for human intricacy. He has agreed to write a guest post here (hopefully not his last — please encourage him!), an insightful look at how “extended periods of prosperity act as an anesthetic in the human brain,” lulling everyone involved into “a drug-induced stupor that causes us to take risks that we know we should avoid.”


Fear, Greed, and Crisis Management: A Neuroscientific Perspective
By Andrew W. Lo
A Guest Post

The alleged fraud perpetrated by Bernard Madoff is a timely and powerful microcosm of the current economic crisis, and it underscores the origin of all financial bubbles and busts: fear and greed.

Using techniques such as magnetic resonance imaging, neuroscientists have documented the fact that monetary gain stimulates the same reward circuitry as cocaine — in both cases, dopamine is released into the nucleus accumbens. Similarly, the threat of financial loss activates the same fight-or-flight circuitry as physical attacks, releasing adrenaline and cortisol into the bloodstream, which results in elevated heart rate, blood pressure, and alertness.

These reactions are hardwired into human physiology, and while some of us are able to overcome our biology through education, experience, or genetic good luck, the vast majority of the human population is driven by these “animal spirits” that John Maynard Keynes identified over 70 years ago.

From this neuroscientific perspective, it is not surprising that there have been 17 banking-related national crises around the globe since 1974, the majority of which were preceded by periods of rising real-estate and stock prices, large capital inflows, and financial liberalization. Extended periods of prosperity act as an anesthetic in the human brain, lulling investors, business leaders, and policymakers into a state of complacency, a drug-induced stupor that causes us to take risks that we know we should avoid.

In the case of Madoff, seasoned investors were apparently sucked into the alleged fraud despite their better judgment because they found his returns too tempting to pass up. In the case of subprime mortgages, homeowners who knew they could not afford certain homes proceeded nonetheless, because the prospects of living large and benefiting from home-price appreciation were too tempting to pass up. And investors in mortgage-backed securities, who knew that the AAA ratings were too optimistic given the riskiness of the underlying collateral, purchased these securities anyway because they found the promised yields and past returns too tempting to pass up.

If we add to these temptations a period of financial gain that anesthetizes the general population — including C.E.O.’s, chief risk officers, investors, and regulators — it is easy to see how tulip bulbs, internet stocks, gold, real estate, and fraudulent hedge funds could develop into bubbles. Such gains are unsustainable, and once the losses start mounting, our fear circuitry kicks in and panic ensues, a flight-to-safety leading to a market crash. This is where we are today.

Like hurricanes, financial crises are a force of nature that cannot be legislated away, but we can greatly reduce the damage they do with proper preparation.

Because the most potent form of fear is fear of the unknown, the most effective way to combat the current crisis is with transparency and education. In the short run, one way to achieve transparency is for our president-elect to convene a “crisis summit” once in office, in which all the major stakeholders involved in this crisis, and their most knowledgeable subordinates, are invited to an undisclosed location for an intensive week-long conference.

During this meeting, detailed information about exposures to “toxic assets,” concentrations of risky counterparty relationships, and other systemic weaknesses will be provided on a confidential basis to regulators and policymakers, and various courses of action can be proposed and debated in real time. Afterward, a redacted summary of this meeting should be provided to the public by the president, along with a specific plan for addressing the major issues identified during the conference. This process would go a long way toward calming the public’s fears and restoring the trust and confidence that are essential to normal economic activity.

In the long run, more transparency into the “shadow banking” system; more education for investors, policymakers, and business leaders; and more behaviorally oriented regulation will allow us to weather any type of financial crisis. Regulation enables us to restrain our behavior during periods when we know we will misbehave; it is most useful during periods of collective fear or greed and should be designed accordingly. Corporate governance should also be revisited from this perspective; if we truly value naysayers during periods of corporate excess, then we should institute management changes to protect and reward their independence.

If “crisis is a terrible thing to waste,” as some have argued, then we have a short window of opportunity — before economic recovery begins to weaken our resolve — to reform our regulatory infrastructure for the better. The fact that time heals all wounds may be good for our mental health, but it may not help maintain our economic wealth.


John

Sir,

Thank you for this post. It is very insightful. I believe that your summit proposal is an excellent idea. The stickiest area as far as public opinion goes would be the idea that the "rich" are being given a "Get Out of Jail Free" card with the confidential transfer of knowledge.

I used to think that generally humans chose to be ignorant, but now may be the time to start educating those who didn't care enough to learn in the past.

jep

So finally there is a good reason to have general anxiety! Those of us with risk aversion and a fear of ending up on the street are saved from the “Good Financial Times Stupor”. We will never be rich. But in these times we feel the urge to say repeatedly “I told you so.” You know, like the hypochondriac who on their death bed can finally exclaim “see I told I was sick.”

Veeresh

I have been a strong advocate of looking all issues based on human behavior. All including religion to science and its use. I am big fan of freakonomics and its rational thinking, what I call. Please keep this kind of articles coming...

Mariano Bartolomei

Mr. Lo's analysis is akin to a dissertation on neurological impulses to a man whose leg is being removed with a rusty saw: all true but perhaps not on the entire target. A huge factor in this "greed" is the cradle-to-grave bombardment that we sustain about "American optimism". Why, it's what every essayist throws in as the differentiating essence of our character vis a vis other cultures. If you don't feel that tomorrow is to be better, for heaven's sakes, go take one of those courses on self-image, life management, attitude, pick one. Abstinence from banal "necessities" and calculation of downsides is for Luddites, sissies and stoics.

Mercutio.Mont

Regulators do not have a propensity to weaken booms. They tend to drive the booms harder.

Most people don't want to pee in the punch bowl. That goes double for politicians.

Sharon

The physiological changes that take place in the "high" of financial wheeling and dealing (gambling included) makes perfect sense to those of us who say "it's the greed, stupid". Madoff and his predecessors have all gotten off on their increasingly illegal schemes to amass wealth. The house of cards has now collapsed and the urge to fight or flee will be superceded by the criminal justice system, which has put the "high rollers" behind bars where they belong, and will do the same to Madoff and anyone else connected with him who hasn't yet committed suicide.

Abigail

This is a brilliant post, with a perspective that extends back through history and into our human core. I love the phrase "behaviorally oriented regulation" - isn't that just what we need?

Thank you for this, Dr. Lo.

Brad

Don't do it!

If you teach the mob how to properly respond to crisis, how are the elite expected to retain their positions by exploiting the mob's emotional reactions?

Matt

What you describe as transparency doesn't sound like the transparency I know. Redacted summery, undisclosed location, confidential. That isn't transparency.

sipa

How can you use the term transparency with 'Confidential' disclosure and 'redacted' (you actually mean censored) summary in the same article and presumably mean them to be consistent.?

As a 'Financial engineer', I would be interested in knowng Professor Lo's views on whether he feels that the 'engineering' of profit without actual productivity through derivates of derivatives played a role in the mess that we are in today.

Otherwise did not see much value to this article

Bill Keller

On weekends, I volunteer among guests at a soup kitchen in Newark, NJ.

I remain grateful to the "guests" of this who weather the hardships that greed at the top inflicts upon them.

They continue to teach me lessons about surviving without the damage that prosperty and greed exacts upon the brains of it restricted beneficiaries.

Ben

A fine idea, but it should probably be noted that the "neuroscience" part of the argument isn't very helpful here. The "monetary gain is like cocaine" thing basically just tells us that monetary gain is pleasurable - almost _all_ pleasurable activities involve the release of dopamine. Saying that "prosperity leads to a drug-induced stupor" isn't quite right, then, or at least tells us nothing more than that pleasurable experiences in general lull us into "a state of complacency." But we knew that already, as anybody who's eaten a big meal or had sex knows.

Not saying that this general prescription might not be correct, but only that the "neuroscience" part tells us much less that is pretends to. It is a nice rhetorical move, though, since it's been shown that adding "neuroscience-y" language or photos of brain scans to arbitrary academic articles tends to make them more persuasive to their readers, whether or not the neuroscience actually has much to do with the article or not.

Read more...

James Morgan

It seems to me candid exchange of ideas always requires some degree of confidentality which runs afoul of transparency. And I believe also that trnasparency is critical. Not sure how you make that work.

Thanks for the thoughts.

JayM

actmanfcb

The need for appropriate regulation is only going to increase over time, I think. Our economy has moved from a manufacturing based economy to one driven by the financial sector. To a large extent, the product offering of the financial sector is debt. To increase profits means to sell more debt. I think it natural that more and more risks will be taken to grow profits, and so it can just be assumed that the financial industry will regularly have melt-downs. These melt-downs affect more of us as this part of the economy grows as a portion of our GDP.

Scott

The highs will need to be balanced with equivalent lows before we can begin to "manage" this. Still many stuck in denial.

I wonder what drug our brain is producing now as we plummet downward. Probably the same as the day after Christmas.

I do think that we will come out of this period as a very different culture. Redirected for the better.

Scott

This sounds lovely. The powerful people who managed the catastrophe that is hurting all of us should sit in a mountain resort somewhere and disburden themselves of all their guilt. Of course, they would have to be offered clemency for any crimes they may have committed—Andrew Lo forgot to mention that, or perhaps he was just being polite, in deference to the sensibilities of these poor wounded souls. And please, let's have counselors lead the sessions, not those nasty regulators. And we can bake tins of muffins and warm up chicken soup to help them feel at ease. Oh, if we just show the rich enough love, I'm sure they'll help us figure out how to clean up the mess they made!

aaron

Neuroscience still has some way to go before it can tell us more about individual psychology than a study, survey, or even though experiment can. For, articles such as this one should be considered pop psychology that has enough references to brain structure thrown in to sound scientific.

JamesLS

Thank you Professor Lo. Your insightful comments brought back the lessons of my youth, provided on a daily basis by my great-grandmother. Having been born in the rural South in 1869 and having lived through several periods of crisis during her 97 years of life, she always had the following words as a rejoinder to cries of woe. "Educate yourself !" (Not infrequently followed by the words: "You ignorant twit.")

Andrew

This suggests that people entering the finance industry should be given attention and working memory training, much the same way children with ADHD should receive.

It has been shown that training working memory improves the symptoms of ADHD, presumably by stabilizing the amount of tonic dopamine in prefrontal cortex.

If we gave investors such training they may be less vulnderable to dopamine highs and more able to act reasonably during bubbles.

Terri Gomez

I'm a personal trainer and I think the financial crisis could be likened to our country's problem with obesity, imo. Notice the language 'too tempting to pass up'.

Gee surprise, massive heart attack. Why can't we restrain our impulses and accept that enough is, well.....enough?