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This link with emotions is what makes many rationalist economists
reject the idea of bubbles. I used to think I knew what the word bubble
meant, but I don't think I know what it means anymore.
I cancelled my subscription to The Economist because the word "bubble" appears three times
in every page there now, and I think it's just totally gratuitous.
It's mindless. Bubbles sound innocuous,
but financial journalist Justin Fox has studied their history
and discovered what happens when they burst. The first financial bubble involved something
highly unlikely. In the 1630s, in the Netherlands,
people were buying and selling Tulip bulbs... complete, mass insanity in Holland, for a
couple of years there, where hundreds of people,
artisans, would leave their workshops and set up business as "florists," they called
themselves, although, for the most part, what they really
were were tulip bulb traders. And it was a real financial market.
The price of tulips in Holland rose to such a level that
the value of one tulip bulb would sometimes be that of an entire house.
Over a three-year period, the price of tulip bulbs rose and rose,
and then began to soar. By some accounts, almost half of all the money
in the Dutch economy was caught up in trades involving tulips.
To a lot of historians, this is really the first example of a financial bubble,
even though it was, basically, tulips. People were buying them,
not primarily because they liked tulips, but they were buying them because they thought
that the price was going up and they could resell them to someone else
at a higher price. On February 5, 1637,
the most expensive bulb in Holland failed to sell, and tulip investors panicked.
Then it burst, because prices start falling. And then they're falling more, and then you
start thinking, "You know, I remember I doubted that tulips
could possibly be worth so much. Maybe I better get out fast."
And then everyone starts dumping, and then it just drops.
As the prices plunged, leading citizens found themselves bankrupt.
Some historians estimate it took a generation for the Dutch economy to recover.
There have been many bubbles and crashes since, but the most famous happened closer to home.
The year 1929 began with optimism. Stock prices had been rising for eight years,
and in '29 they were soaring. The 1920s was a great decade economically.
The economy was booming, industry was booming, and toward the latter part of the decade,
financial markets just sort of went from reflecting that boom to, kind of, creating it.
It was just boom times all over. By the late 1920s, there was just this feeling
of a new era. Observers described feverish emotions,
as thousands of investors paid ever-higher prices for stocks.
In the so-called "roaring '20s" the stock market went through an enormous
bubble; people thought it would never end.
But then, on October 29th, prices suddenly dropped,
and the mood turned to one of panic and fear. Over 9,000 American banks failed, wiping out
the life savings of millions. It led to a depression that lasted over 10
years. We had 25 percent unemployment for most of
the decade of the 1930s. It was an event that was driven by a real
change in people's psychology that lead them to be very optimistic and positive
in the 20s and then negative in the 30s.
This view that emotions can drive an economy up or down
became the conventional wisdom of the 1930s, through the work of the renowned British economist
John Maynard Keynes. JOHN MAYNARD KEYNES (Economist): There's a
Keynes believed that financial markets arrived in a pretty crazy fashion.
His classic quote is that the market could stay irrational longer than
you can stay solvent. Keynes said emotions could cause prices to
soar and then collapse, and to protect the economy from these dangerous
bubbles, the markets had to be firmly regulated by
government. Keynes, though, could never explain exactly
what the mechanism was. Keynes never got past the fuzzy stage,
and it didn't lead him to a precise mathematical model.
And that's why, ultimately, Keynes was rejected by the profession.
Now, after the crash of 2008, behavioral economists are struggling to do
what Keynes could not: show precisely how human emotions affect prices.
Their ideas are so influential that behavioral experiments are now conducted even
at the University of Chicago, the citadel of rational economics.
One explores a mysterious psychological bias. We are interested in
how much you would pay for this mug or one identical to it.
These students have been told to work out the price of a common consumer item.
...a travel mug, in beautiful maroon. They're asked, first,
what they would be prepared to pay to buy the mug.
Let's think about it for a moment and then write down the maximum amount
you'd be willing to pay for this mug or one identical to it.
They offer an average of six dollars. So we now have six of these mugs.
We're just going to raffle them off by selecting a few people at random.
And then they're given the same mug for nothing. An hour later, they're asked how much they'd
be willing to sell it for. In rational economics, the price should be
exactly the same. After all, the value hasn't changed.
But the average price they want for the mug now is nine dollars.
...wanted to sell the mug back, once you had it, you gave a higher price.
RESEARCH SUBJECT ONE (University of Chicago):It just made it seem a little bit more special,
because it was going to be something useful to me.
Anybody else? RESEARCH SUBJECT TWO (University of Chicago):
Well, I got this mug by complete luck, and so it's important to me,
and so I have to charge this much for it. The emotional pleasure of owning something
for just an hour pushed the price up by 50 percent.
It's an unexpected outcome, suggesting we are unaware of the emotions
that drive this behavior. At Harvard, researchers are exploring the
financial impact of these subtle influences. The team is led by Jennifer Lerner.
I'm a social psychologist, not a clinical psychologist.
I don't do counseling, therapy, et cetera. I do experiments in a laboratory.
I come with the assumption that much of what's going on in terms of influencing
a decision is outside of conscious awareness.
Lerner explores all sorts of emotions. Today it's sadness and how it impacts on financial
decisions. We're going to start by placing these two
sensors. They measure skin conductance, or sweating
response. The experiment is designed to induce emotions
at such a low level that the subjects aren't aware of them.
...fairly snug. It's going to measure your skin temperature.
So the researchers use sensors to track the physiological effects of the
emotion... So now we're going to get ready
to collect the first saliva sample. ...from heart and breathing rate, to the hormones
in saliva. These are physiological signals from the subjects.
When we have them first come in, they sit and have a period of quiet rest,
relaxing to music, that sort of thing, so we can see what they're like at baseline.
And then we use that to compare what happens when they might be in the midst of a stressful
financial decision. Among other activities, the subjects watch
a scene from a sad movie. Unbeknownst to them, this triggers low-level
sadness. Their sensors reveal the emotional change.
The decision-makers in our studies are completely unaware that the sadness is
impacting them. And when we ask them,
did the film you saw change your responses in any way,
they say no. It's time for the financial test.
The subjects are directed to make a series of financial choices.
Then, they are asked how much they would pay for a consumer product,
in this case, a water bottle. Lerner compares their choices to those of
a group not shown the sad video. Here is an example of a subject in the neutral
condition, and this subject is telling us that
they would like to buy it at two dollars and fifty cents.
And that contrasts with, here, we have data from a subject who's in the sad
condition, and this subject is willing to pay $10 to
obtain the water bottle. And that is very representative of what we
see. You get this increased valuation when you're
sad. If sadness can lead people to pay four times
more for a water bottle, what happens when the stakes are higher?
The experiments have been done with high stakes money
—a thousand dollars, et cetera— and what we find is that these results scale
up, even when you use big money.
If emotions influence prices on the individual level,
what about markets and the larger economy? According to rational economics,
these are driven by individual self-interest, but for Robert Shiller, this ignores something
obvious. Humans are empathetic animals,uniquely empathetic.
We're not just communicating ideas, we're communicating emotions.
That's what empathy means. It's different from sympathy.
It's that I am feeling the same thing; I know what you're experiencing because it's
in my body too, the same feeling that you have.
There's a hot real estate market in many parts of the country right now.
If Shiller is right, could empathy explain how the hyper-optimism
of the housing market jumped, like a social contagion, to the financial
markets? The real estate market has grown to new heights
and new prices. Among professional traders,
the idea that moods sweep through markets is taken for granted.
DAN MATHISSON (Credit Suisse): The market is an aggregation of what thousands of people
think the future is going to be like. And if these people are optimistic about the
future, the market goes up, and if people are pessimistic about the future,
the market goes down. But at the end of the day, the question the
market answers is, "Are people optimistic or are they pessimistic?"
And that's a psychological question. Emotion still drives the markets.
They're saying that the bubble will not burst, there's plenty of room left to run.
For rationalists, emotions are not a satisfactory explanation for how markets work.
The observation that people feel emotions means nothing.
And if you're going to just say markets went up
because there was a wave of emotion, you've got nothing.
That doesn't tell us what circumstances are likely to make markets go up or down.
That would not be a scientific theory. The rationalists' conviction is based on
the mathematical model they use to understand the financial markets.
It's called the "efficient markets hypothesis," and it says that financial markets act, essentially,
like a giant calculating machine, efficiently processing all relevant information
faster than any individual could. So, if some traders are emotional, it doesn't
matter. Efficient markets can exist side by side with
irrational behavior, as long as you have enough rational people
to keep prices in line. In the efficient markets model,
the financial markets themselves are rational, and prices, at any moment in time, cannot
be wrong. It was a model invented by Eugene Fama.
It's a pretty good model. And for almost every practical use you would
put that model to, it works pretty well.
It created a big fuss and the fuss persists to this day.
The fuss persists because, for many behavioralists, the theory implies financial markets should
be immune from criticism or control. The theory is that we have to look at markets
as oracles. When the market moves up, we have to say,
"What is the wisdom of the market telling us, today?"
If markets are efficient, there's no real need for government,
because the market itself will make sure that prices are always equal
to the right price. Instead of regulation,
rationalists believe the markets will come up with their own mechanisms for managing
risk. And so they have.
The first was invented here at the Chicago Mercantile Exchange,
where traders handle vast sums of money, all the time.
HARRY PANKAU (Chicago Mercantile Exchange Trader): I'm an independent trader, and I
trade my own money, 50 contracts to 100 contracts at a time.
That's basically a 50-million to 100-million-dollars contract size.
Traders here make their money by effectively offering to insure people against risk,
including agricultural producers of pork bellies and oranges.
Long before this orange became an orange, the farmer had to grow it.
He doesn't know what will be the price of that orange
when it comes to the market, finally, 10 months later.
Will he make a profit? As protection, farmers take out contracts
to insure themselves against the price of oranges dropping�