The Science of Economic Bubbles and Busts

It is great to see the new trend in economics--behavioral economics, finance economics, and neuroeconomics--away from classical economic theory to an investigation of the role of psychology in making economic decisions. What is next? An investigation of the role of socal structure and cultural schemes in economic markets:) I hope you enjoy the following article and I look forward to any reaction.

Gary Stix--Even people who do not use illicit drugs or get shot in the head have to contend with the reality that some of the decisions cooked up by the brain’s frontal lobes may lead them astray. A specific site within the prefrontal cortex, the ventromedial prefrontal cortex (VMPFC) is, in fact, among the suspects in the colossal global economic implosion that has recently rocked the globe.

The VMPFC turns out to be a central location for what economists call “money illusion.” The illusion occurs when people ignore obvious information about the distorting effects of inflation on a purchase and, in an irrational leap, decide that the thing is worth much more than it really is. Money illusion may convince prospective buyers that a house is always a great investment because of the misbegotten perception that prices inexorably rise. Robert J. Shiller, a professor of economics at Yale University, contends that the faulty logic of money illusion contributed to the housing bubble: “Since people are likely to remember the price they paid for their house from many years ago but remember few other prices from then, they have the mistaken impression that home prices have gone up more than other prices, giving a mistakenly exaggerated impression of the investment potential of houses.”

Economists have fought for decades about whether money illusion and, more generally, the influence of irrationality on economic transactions are themselves illusory. Milton Friedman, the renowned monetary theorist, postulated that consumers and employers remain undeluded and, as rational beings, take inflation into account when making purchases or paying wages. In other words, they are good judges of the real value of a good.

But the ideas of behavioral economists, who study the role of psychology in making economic decisions, are gaining increasing attention today, as scientists of many stripes struggle to understand why the world economy fell so hard and fast. And their ideas are bolstered by the brain scientists who make inside-the-skull snapshots of the VMPFC and other brain areas. Notably, an experiment reported in March in the Proceedings of the National Academy of Sciences USA by researchers at the University of Bonn in Germany and the California Institute of Technology demonstrated that some of the brain’s decision-making circuitry showed signs of money illusion on images from a brain scanner. A part of the VMPFC lit up in subjects who encountered a larger amount of money, even if the relative buying power of that sum had not changed, because prices had increased as well. (more)

If you like this, then here are a few books you should read:

Shiller, Robert. 2008. The Subprime Solution: How Today's Global Financial Crisis Happened and What to DO about It. Princeton University Press.

Akerlof, George A., and Robert Shiller. 2009. Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism. Princeton University Press.

Thaler, Richard H., and Cass Sunstein. 2009. Nudge: Improving Decisions about Health, Wealth and Happiness. Penguin Books.

Ariely, Dan. 2008. Predictably Irrational: The Hidden Forces That Shape Our Decisions. HarperCollins.

The Changing Role of Technology in Social Movements

The recent turn of events in Iran have brought to the forefront the changing role of technology in social and political movements. There are those who argue that new media technology allows for the possibility of significant political resistance--and potential revolution. Others say that it is epiphenomenal to the larger organic social movement. However, I believe that we should understand the pros and cons of these new technologies and their potential role in the geo-political landscape. With this in mind, here is an interesting article by Noam Cohen spelling out the strengths and weaknesses of the micro blogging service called twitter.

Political revolutions are often closely linked to communication tools. The American Revolution wasn’t caused by the proliferation of pamphlets, written to whip colonists into a frenzy against the British. But it sure helped.

Social networking, a distinctly 21st-century phenomenon, has already been credited with aiding protests from the Republic of Georgia to Egypt to Iceland. And Twitter, the newest social-networking tool, has been identified with two mass protests in a matter of months — in Moldova in April and in Iran last week, when hundreds of thousands of people took to the streets to oppose the official results of the presidential election.

But does the label Twitter Revolution, which has been slapped on the two most recent events, oversell the technology? Skeptics note that only a small number of people used Twitter to organize protests in Iran and that other means — individual text messaging, old-fashioned word of mouth and Farsi-language Web sites — were more influential. But Twitter did prove to be a crucial tool in the cat-and-mouse game between the opposition and the government over enlisting world opinion. As the Iranian government restricts journalists’ access to events, the protesters have used Twitter’s agile communication system to direct the public and journalists alike to video, photographs and written material related to the protests. (As has become established custom on Twitter, users have agreed to mark, or “tag,” each of their tweets with the same bit of type — #IranElection — so that users can find them more easily). So maybe there was no Twitter Revolution. But over the last week, we learned a few lessons about the strengths and weaknesses of a technology that is less than three years old and is experiencing explosive growth. (more)

How Pharma and Insurance Intend to Kill the Public Option

I am cautiously optimistic about the up coming battle for a public healthcare option. I have been scanning the cable news channels, the dominant newspapers, and the blogs. They all point out that there is an intensifying debate in Washington and things are going to get worse. Leading the opposition, ironically, is the American Medical Association. The AMA is letting Congress know that it will oppose creation of a government-sponsored insurance plan, which President Obama and many other Democrats see as an essential element of legislation to remake the health care system. Additionally, as Reich points out, the opposition is coming from Big Pharma and Big Insurance. Enjoy the article below and let your representative and senators know you want a public option without conditions.

By Robert Reich--

I'ved poked around Washington today, talking with friends on the Hill who confirm the worst: Big Pharma and Big Insurance are gaining ground in their campaign to kill the public option in the emerging health care bill.

You know why, of course. They don't want a public option that would compete with private insurers and use its bargaining power to negotiate better rates with drug companies. They argue that would be unfair. Unfair? Unfair to give more people better health care at lower cost? To Pharma and Insurance, "unfair" is anything that undermines their profits.

So they're pulling out all the stops -- pushing Democrats and a handful of so-called "moderate" Republicans who say they're in favor of a public option to support legislation that would include it in name only. One of their proposals is to break up the public option into small pieces under multiple regional third-party administrators that would have little or no bargaining leverage. A second is to give the public option to the states where Big Pharma and Big Insurance can easily buy off legislators and officials, as they've been doing for years. A third is bind the public plan to the same rules private insurers have already wangled, thereby making it impossible for the public plan to put competitive pressure on the insurers...

This is it, folks. The concrete is being mixed and about to be poured. And after it's poured and hardens, universal health care will be with us for years to come in whatever form it now takes. Let your representative and senators know you want a public option without conditions or triggers -- one that gives the public insurer bargaining leverage over drug companies, and pushes insurers to do what they've promised to do. Don't wait until the concrete hardens and we've lost this battle. (more)

Poking Holes in a Theory on Markets

Having spent many years debating my economist friends from the University of Chicago, this article gives a nice overview of the problems with one of the dominant economic theories of our time--efficient market hypothesis. I hope you enjoy and I look forward to any responses.

For some months now, Jeremy Grantham, a respected market strategist with GMO, an institutional asset management company, has been railing about — of all things — the efficient market hypothesis.

You know what the efficient market hypothesis is, don’t you? It’s a theory that grew out of the University of Chicago’s finance department, and long held sway in academic circles, that the stock market can’t be beaten on any consistent basis because all available information is already built into stock prices. The stock market, in other words, is rational.

In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices — meaning that perhaps the market isn’t quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.

These days, you would be hard-pressed to find anybody, even on the University of Chicago campus, who would claim that the market is perfectly efficient. Yet Mr. Grantham, who was a critic of the efficient market hypothesis long before such criticism was in vogue, has hardly been mollified by its decline. In his view, it did a lot of damage in its heyday — damage that we’re still dealing with. How much damage? In Mr. Grantham’s view, the efficient market hypothesis is more or less directly responsible for the financial crisis. (more)

President Obama’s Speech to the Muslim World

This was a wonderful speech by President Obama yesterday in Cairo, Egypt, outlining his personal commitment to engagement with the Muslim world, based upon mutual interests and mutual respect, and discusses how the United States and Muslim communities around the world can bridge some of the differences that have divided them. June 4, 2009. I hope you enjoy!