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

Andrew 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.