Saving the economy from our brains
Our brains are wired for bubbles, it would appear, and regulation and tight external controls are the only way to save ourselves from ourselves.
Bankers, traders and investors effectively became addicted to the pleasure that comes from making money, while at the same time increasingly losing touch with just how much risk they were taking.
The result was a bubble in risk taking, debt and many financial assets and the inevitable crash and complete pull back in activity.
“The finance industry was adapting to the level of risk,” said Gregory Berns, a professor of neuroeconomics at Emory University in Atlanta who uses brain scanning technologies to try and decode the decision-making systems of the brain.
“It is an insidious process, you are not aware of it. You are addicted to returns, you are addicted to risk, you are addicted to cocaine — it’s all the same as far the brain goes.”
Berns, who says that the brain has no mechanism for being satisfied, compares the process of becoming adjusted to new stimulus such as making money or taking risks to the eyes adjusting to the light; while at first it seems bright, your brain adjusts and you no longer perceive the light as bright, the money as enough, the risk as high.
So in order to get the same buzz from making money you have to up the stimulus, doing more of what it was that brought in the money in the first place. At the same time your perception of risk becomes less sharp.
So with the same regret that a recovered alcoholic looks back on driving after seven martinis, we all now look back on an investment bank with a 40-1 leverage ratio.
Seemed like a good idea at the time, but an addiction like any other. Berns, an outsider to finance, looks at other addictions and concludes that what’s most likely to succeed is a system of controls imposed from outside, namely government regulation.
“It needs an imposition from outside; addicts have a difficult time self-treating, it needs structure.”
But that of course is complicated by the fact that what government and the rest of us want the banking industry to do is not go off risk cold turkey but to control the amount of risk it takes so that enough credit is created to allow the economy to grow. So it’s a bit like a 12-step addiction program that meets in a bar and in which the object is not sobriety but being just pleasantly tipsy. It’s a hard ask.
SOMEONE TO WATCH OVER ME
People who are against government regulation will say: why do we think governments are going to be better at figuring out what is risky? But if you look at it from the point of view both of compensation and conflicts of interests, and of brain chemistry and psychology, you will see that is not the point.
Governments are probably marginally more hopeless than bankers or the markets at figuring out what is what in the beginning, just as the guy in the risk department at Big Bank plc knows a lot less about the derivative market than the physics PhD he has to oversee. But the person with the most to gain from the activity is the person most likely to have his opinions distorted over time. The important thing is to be beholden to someone with oversight and power who will check your natural tendency to get carried away.
We simply need outside controls, both in terms of company controls and government controls, to help stop us from deluding ourselves.
James Montier, a strategist at Societe Generalein London and an expert in behavioral finance, says that our beliefs about our abilities and future behavior is often profoundly out of step with reality.
People believe they will act in one way when contemplating an emergency, for example, and then act in quite a different one in the heat of the moment. The solution is harder rules and more process, just as data has shown that even the most experienced surgeons have better outcomes if they use something as simple as a checklist.
“What it drives you to is the primary role that process has to play in investment,” Montier said.
“You can’t control return, can’t control risk; all we can control is how you approach investment.”
The fact is that controls are needed. Parts of the system like hedge funds which have no call on state insurance if their bets go bad would be well advised to put in their own controls. Those parts which we all seem to be insuring need to have those controls imposed from on high.
Those controls will be circumvented and worn away by future successes, but that is no reason not to try.
— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click here. . —