Neoclassical Economics, Neuroscience, and Asset Bubbles

Reading economics blogs can provide real insights into how contemporary economists view the world. Understanding how economists think can go a long way in explaining why they say the things they say and how decisions affecting millions of people come to be.

Reading economics blogs can be fun too, as some economists maintain a quirky, yet lovable, sense of humor. This may sound like an odd view for a blog with a name such as this one, but not really.

Long ago, we made the invaluable observation that most people go through life looking for confirmation of what they already believe. Only a small minority constantly seek new thoughts and opinions or, better yet, views that are contrary to their own.

Only a select few desire a constantly expanding base of personal knowledge and a sort of testing, as it were, of privately held views to repeatedly evaluate whether these views merit continued belief.

That is what this blog has in common with Dr. James Hamilton's blog - there may not be much else.

Dr. Hamilton is a Professor of Economics at the University of California, San Diego and writes the blog Econbrowser. It has been nominated for awards and is very popular. Today's post was inspired by an item that appeared last week on Dr. Hamilton's blog titled, The Neoclassical Paradigm.

It began with the circumspection, "Do economists have a sensible way of thinking about the world?"

Dr. Hamilton goes on to describe neoclassical economics, brain imaging studies demonstrating how financial decisions can be driven by emotion, and offers the following reasons why neoclassical economics is still valuable:

• Reward or punishment will mitigate the influence of emotion on financial decisions
  
• Unsuccessful, emotional investors will remove themselves as price-setters in markets
• Neoclassical economics provides a structured and disciplined approach to modeling

He concludes by offering hope that Homo economicus, though flawed, offers the only enduring model of the actors that drive an economy.

Neoclassical Economics Today

So, what is neoclassical economics? It is composed of three principles:

• People have rational preferences
  
• Individuals seek to maximize their happiness or satisfaction (utility)
• People act independently on the basis of full and relevant information

This all seems to make good sense when the preferences involve laundry detergent or Popsicles, or when decisions are made in fairly well controlled environments, but does this model really apply to asset classes such as equities and real estate?

With the recent history of a stock market bubble followed by a housing bubble, is this model still useful? Specifically, as to the three tenets of neoclassical economics,

• Are the decisions of stock and housing purchases rational?
• Does utility maximization apply when capital appreciation is involved?
• Do people really understand what it is they are doing?

Until ten years ago when asset prices began their meteoric rise, aided by new technology and the participation of individuals as never before in history, none of these questions seemed germane to mainstream economic thought.

Stocks were purchased by wealthy individuals or pension funds, rather than common laborers - the intricacies of trading on Wall Street were unknown to, and out of reach of, the common man.


The barrier to entry for housing was much higher than it is today - both interest rates and lending terms were far less accommodative and real estate was considered a place to live and raise a family, rather than as an investment or a source of income.

Given the restricted set of actors up until about ten years ago, claims of rational behavior, utility maximization, and good information seemed reasonable to make.

But, with today's "ownership society", ordinary people are required to make more and more decisions that will affect their economic well-being in very tangible ways. And, with a delayed feedback mechanism inherent to stocks and housing, this model seems less applicable.

Today, decisions seem to be much less rational and information used to arrive at these decisions, while plentiful, seems to be increasingly suspect. At the same time, the desire to maximize happiness seems to be stronger than ever.

The Mortech Example

Consider the case of a typical subprime borrower visiting the office of the Mortech Financial Group, as discussed in these pages last week. Is the decision to buy property a rational one, when, by any historical measure, this property is wildly overpriced?

After completing the purchase using a very non-traditional type of financing, this market participant becomes a price-setter, adding a data point for all those who look to make similar purchases in the future.

Though this purchaser's decision was based more on monthly payments than price paid, the price paid affects other market participants in very profound ways.

Whether the buyer really understood the terms of the agreement to which he is now bound, or its long-term implications, the price paid becomes the measure against which other home values are judged.

The Lessons of Neuroscience

As in the case of the subprime borrower, emotions play an important role in decision making today - recommendations from friends and family, falling in love with the kitchen, and male adequacy in providing for a family all factor into the decision making process.

How emotion affects decision making has been the subject of increased study in recent years as discussed in Dr. Hamilton's post last week, where he looked at the Ultimate Game experiment as detailed by Princeton psychology professor Jonathan Cohen in these recently published works:

The neural basis of economic decision making in the ultimatum game (PDF)
The vulcanization of the human brain (PDF)

The Ultimatum Game works as follows:

In this game, a pair of partners is given an endowment that they must split. One partner proposes how to split the sum, and then the other may accept or reject the offer. If the offer is accepted, each player is allotted the proposed amount. If the split is rejected, neither partner receives anything, and the game is over.

Standard economic theory suggests that any split offering a small but nonzero amount should be accepted. After all, for the partner who must decide whether to accept or to reject the offer, something is better than nothing. However, offers of less than about 20 percent of the sum are routinely rejected, even though this means getting nothing.

So, even in the case where there is no time element involved, the rational calculation of the partner choosing whether to accept or reject the split becomes emotion-filled and irrational - a present reward is forfeited with no offsetting future benefit, so that the other partner can be punished for the slight.

Any non-zero offer, it seems would be beneficial to the partner making the accept/reject decision, yet when an offer of below 20 percent is tendered, often times strong activity is triggered in parts of the brain associated with "negative emotional responses such as physical pain and disgust".

This normally leads to rejecting the offer.

In a similar experiment reported in this Wall Street Journal article last July, a study concluded that people with a certain type of brain damage made better investment decisions than others. The participants had damage in an area of the brain that controlled emotions which prevented them from feeling fear or anxiety, and as a result, in the simulated investment game, they came out ahead of their unimpaired competitors.

When studying the brain activity as it related to decision making in a game of speculation and expectations of future monetary reward, they concluded the following.

In one study, the pair used gambling games and neuroimaging techniques to look at what part of the brain is triggered when people anticipate winning money. They found that monetary rewards trigger the same brain activity as good tastes, pleasant music or addictive drugs.

Yes, the anticipation of monetary rewards stimulates the same area of the brain as good food and addictive drugs, rather than areas associated with higher cognitive functions.

Still Useful?

So, in today's world of an increasing number of decisions to be made by more people, amid a rapidly increasing amount of sometimes conflicting information, during an era of multiple asset bubbles that can quickly reward and belatedly punish risk takers, is neoclassical economics still useful?

In response to Dr. Hamilton's rationale above, it hardly seems that the reward or punishment intended to mitigate the influence of emotions comes in a timely enough manner to affect future investment decisions. The nature of asset bubbles is that they go on for long periods of time - everybody comes to believe that it's different this time, and then reality sets in.

Deferred punishment for irrational exuberance in the late 1990s was not meted out until years later. Time will tell how the housing bubble resolves itself, but surely punishment awaits many.

As for unsuccessful, emotional investors removing themselves from the markets, it seems the opposite is true, and to a large degree. Emotional investors, momentum traders, and condo-flippers become emboldened and then draw other emotional investors into the market - the essence of a speculative mania.

In the end, an early exit would have saved many late adopters from much anguish. Those cajoled to join the real estate investment party in 2005 will likely have been better served if the condo-flippers were removed in 2004.

And lastly, does neoclassical economics provides a structured and disciplined approach to modeling behavior such as that seen in today's asset markets?

Who knows?

Things might be a lot easier to understand without all the bubbles.