I was reading Scientific American on the plane, and usually can't stand their smarmy, PC take on everything. In July's issue, they didn't fail me. Their article Science of Economic Bubbles and Busts seemed to uncover "the promise of changing forever our fundamental assumptions about the way entire economies function", using "a high tech fusing of neuroimaging with behavioral psychology." The result would show an "economics [that] has begun to proved clues to how individuals, and, aggregated on a larger scale, whole economies may run off track." OK, do tell!
Great, what are these insights?
- how could markets be 'efficient' if prices can fall so precipitously?
- people buy based on gut feelings (animal spirits)
- people dislike losses more than they appreciate gains
- people use rules of thumb, heuristics such as anchoring on a set of base information (that may be arbitrary), or the whatever is easiest to remember (which may not be more important)
- markets may work like ecosystems, where the most profitable survive
There are several more in this vein. These ideas are true, but they have all been around for at least 30 years. Sure, now we can model fMRI that shows what part of the brain lights up when we lose money, but that has not shown anything other than that there is a biological substrate to human thought, which I don't think anyone ever doubted. It isn't obvious how these facts are related to some better model of finance, because it's not like thousands of smart people haven't been working with them for decades. Of course economists are predicting the effects of individuals interacting, and these people have emotions and are not perfect. The problem is most of these 'biases' tend to cancel out or are ambiguous. For example, there are biases of over and under-extrapolation that will explain both mean reversion and momentum.