Questioning ‘Rationality’ and the myth of Homo Economicus – The case of Amygdala taking over in market crashes and finding answers in NEURO-ECONOMICS

Sir Robert must have patted himself on the back when he installed Mir Jaffar as the Nawab of Bengal in 1757 after killing Nawab Siraj-ud-daulah in the Battle of Plassey.

“What a jolly good day!” he must have remarked as he got dressed on the morning of 24th June, 1757, for this would be a day of celebration from what would become his most remembered military success.

Of course no one really pays attention to the historical footnote that the success of this battle rested not in the brilliance of military tactics or political acumen but on the treachery of Mir Jaffar to his master Siraj. Clive was confident of this characteristic in Jaffar. He knew Jaffar’s Amygdala will drive him to betray his master and to play into the hands of the East India Company- the undisputed pioneers of corporate globalization in at least the Indian Sub-continent. So did Sir Robert Clive make a name in history based on his impeccable application of the Rational Choice Theory, calculating that since Jaffar preferred ruler ship of Bengal over kin, he would be willing to overthrow his own and side with the British businessmen even if it meant nominal leadership, because Jaffar was Transitive in choosing a ‘bundle of goods’. Or did he rely on the emotional response of a human brain to a given a situation where he has a sense of being wronged?

Either way his calculations were pretty much on point and the Crown as well as the ‘House of Commons’ were rather supportive until 1769, when Haider Ali of Mysore captured the fort of Malbagal, St George and eventually the town of Madras. All the executive decisions by the Court of directors and calculations from the Crown regarding Bengal[1] being the most valuable territory from an economic (read extortionist) point of view, sort of fell flat on their face. When the news reached London in the May of 1769, the market crashed. The East India Company faced its Great Crash that summer when stock price fell from 284 to 122 pounds on the London Stock Exchange. All policy decisions regarding recognition of Sovereigns of Indian subcontinent within the British Empire and maintaining “legitimate trading activities without securing the addition of further political and administrative burden” were rendered meaningless in the light of circumstances that Sir Clive and his peers had somehow missed for effective inclusion in their ‘prediction model’. But the markets had responded in what modern day neuro-economists would classify as the most predictable human response to an uncertain situation.

An example for a more recent event in history might better serve us. Most of my generation has only heard of the Great Crash of 1929 and its comparison to the financial crisis of 2008, the horrific aftershocks of which still impact my generation’s decision making. From making career choices to spending patterns (yes, we’d rather spend our hard-earned savings on taking a vacation because who knows what happens to property and youth won’t last forever). The US economy was doing great back then. There was a surplus of agricultural produce, industries especially steel and iron were doubling their returns, and the favorite of many stock market investors, the P/E ratio, of S&P Composite stocks was 32.6 in September 1929, clearly above historical norms. The likes of famous economists like Irving Fisher (famous for his mathematical modelling in financial analysis) had proclaimed, “Stock prices have reached what looks like a permanently high plateau.” And yet when the slide turned into a crash, there was no stopping it. Over the course of modern history, market crashes have one thing in common, PANIC SELLING.

But wait! Why?

Are we not supposed to be rational beings, who make their financial decisions based on careful calculations and deliberation? Is it not sound intellectual practice to weigh the pros and cons of a decision? Should we not compare the Price-over-Earnings ratio of a stock and its market price and make our buy and sell decisions based on the over-valuation and under valuation of a stock? Should we not always prefer to exploit an arbitrage opportunity? Save that $10 while buying a radio worth $35 at a shop nearby which sells at $25 in the neighborhood 20 minutes away but also when buying a television worth $450 in a shop nearby, which costs $440 in the neighborhood 20 minutes away.

Can this be the reason why financial modelers, mathematicians, economists and analysts at large fail to see the bubbles when they are in the making and fail even more terribly at predicting a crash?

Ever heard of Herd Mentality? (Look what I did there!)

A whole new field of economists and financial analysts has taken birth in the advent of an age of frequent market crashes. They have a one word answer for it. Herd mentality. Ever wondered how a herd thinks? I saw that raised eyebrow. Yeah, you are right. They don’t. Quite appropriate for describing the panic stock markets face in crashes right?

This phenomena got its name based on an analysis of empirical data they have gathered from the many market crashes in history. Have a look at this list.[2] But why on earth does someone need to describe human behavior in the markets as akin to beasts in the wild? Why couldn’t someone just figure out an explanation based on transitively consistent choices? Oh wait, how about utility maximization? Maybe, all these panic sellers were maximizing their utility by selling their stocks at a loss? Why does something massively contradictory to sound financial practices, makes more sense than standard finance and economic theory?

Could it be possible that economists got RATIONALITY wrong?

Could it be that Homo Sapiens are simply just that and not Homo Economicus?

To me even the Herd Mentality explanation did not make sense. It seemed like a partial explanation. Where do we get this herd mentality? Is there a way we can overcome this? Many questions bothered me and I delved into New Economic Thinking, exploring unorthodox ways of thinking about economic and social problems that plague the modern, economically and socially hyper-connected world. From Behavioral Finance to Behavioral Economics, to Experimental Economics (I even designed a risk game which showed that people take risks even when there is no extra reward for it- a contradiction to sound rational financial theory of Market Portfolio). It seemed to make only partial sense. I soon began to realize that Economics (god-forbid) was an incomplete science on its own. It needs an interspersion with discourses from other social sciences that focus on the Homo Sapien. I began to seek answers from sociology, anthropology, psychology and even literature. It still seemed like an incomplete story. Maybe economics needs to drink from a bigger cup. I sought refuge in the hard sciences. Little digging into literature and I ran into the criticism economists already face, The Physics Envy. It seemed rather ‘rational’ to me that more math was not helping anyone. Mathematical models seemed to miss the point altogether. The famous Black-Scholes and Myers model missed it terribly[3]. Their mathematical model, very sophisticated and complex had somehow just not been able to factor in the circumstances that led to the military coup in Thailand that year that proved to be a catalyst to the downfall of Long Term Capital Management (LTCM), the profit making center the three mathematicians had established based on their options pricing model.

I turned to the life sciences. Evolutionary biology and Neuroscience. It seemed like another range on the spectrum of answers was opened up to me. This lens made sense when applied to anything I read about human civilization and behavior, in any domain whatsoever. The ideas that Kahneman popularized about the human cognition, naming them System 1 and System 2,[4] had basis in human physiology. The human brain has physical spaces through which emotions are modulated and critical thinking resides in. Below I endeavor to explain in simple language, my infantile attempts at marrying economics with neuroscience, in order to make more sense of the world around me.

Market crashes made all the more sense to me when I understood that the anterior cingulate cortex (involved in emotion modulation) and the pre- frontal cortex (involved in critical thinking and decision making) is overtaken by the amygdala whenever it senses danger in its surroundings. This function of amygdala is rooted in our biology. In the pre-historic era, the human brain’s neo-cortex was still not fully developed[5] and our ancestors relied on sensory inputs from the brain and body to ensure their survival. The brain was trained to be alert to threats from the environment, mostly larger predatory animals. The brain’s system evolved in such a way that made the body more aware of its surroundings by raising adrenaline and cortisol levels in the system, to be able to respond swiftly to impending gloom. That mentality has stayed with us long after existential threats have ceased to hold power over us. So today, even in our culturally crafted environments that present us with no mortal danger, the amygdala in our brain responds in exactly the same way as if the danger was detrimental to our existence, when markets begin to slide. This may seem like a simplistic explanation because it is. There is more to this analysis than meets the eye, but lack of space and the realization that the human brain’s concentration spans on average at about ten minutes, I rest my case for the day.

However, I am not the only one who took this journey through the sciences. Thinkers in economy, philosophy and psychology have made a clearing in the dense forest and enabled the birth of a new discipline, Neuro-Economics. It is a concoction of psychology, neurology, biology, philosophy, history and economics. It seeks to fill that knowledge gap that economics on its own has been unable to. Still, the story is not complete, but with the addition of this vantage point in the repertoire of lenses available to thinkers of the 21st century, we might get rather close to the while picture.

 

[1] Revenue and Reform: The Indian Problem in British Politics 1757-1773 by H.V Boven

[2] http://list25.com/25-of-the-worst-stock-market-crashes-in-history/

[3] https://www.theguardian.com/science/2012/feb/12/black-scholes-equation-credit-crunch

[4] http://bigthink.com/errors-we-live-by/kahnemans-mind-clarifying-biases

[5] https://www.amazon.com/000-Year-Explosion-Civilization-Accelerated/dp/0465020429

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2 thoughts on “Questioning ‘Rationality’ and the myth of Homo Economicus – The case of Amygdala taking over in market crashes and finding answers in NEURO-ECONOMICS

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  1. Hello Komal, in your search for alternative economic thinking, have you looked at the science of Cybernetics and Systems Thinking? ref. http:// SCiO.org. My own view is that an economic system is an operating system that governments and citizens use to make a living. The policies that governments introduce are mere “bug fixes” and “patches” for a dysfunctional economic operating system. Governments could very easily legislate an alternative economic framework into existence and use their respective taxation systems to create “causal loops” to produce ethical, fair and just economic behaviours. “Booms” and “Busts” could be designed out of the economic system. I believe I have designed and published just such a system.

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