Article of the week (26/2009): The Science of Economic Bubbles and Busts
Posted on June 27, 2009 in Finance
This week’s article is The Science of Economic Bubbles and Busts by Gary Stix. Following is a small excerpt:
It has all the makings of a classic B movie scene. A gunman puts a pistol to the victim’s forehead, and the screen fades to black before a loud bang is heard. A forensic specialist who traces the bullet’s trajectory would see it traversing the brain’s prefrontal cortex—a central site for processing decisions. The few survivors of usually fatal injuries to this brain region should not be surprised to find their personalities dramatically altered. In one of the most cited case histories in all of neurology, Phineas Gage, a 19th-century railroad worker, had his prefrontal cortex penetrated by an iron rod; he lived to tell the tale but could no longer make sensible decisions. Cocaine addicts may actually self-inflict similar damage. The resulting dysfunction may cause even abstaining addicts to crave the drug any time, say, the thudding bass of a techno tune reminds them of when they were stoned.
Even people who do not use illicit drugs or get shot in the head have to contend with the
reality that some of the decisions cooked up by the brain’s frontal lobes may lead them astray. A specific site within the prefrontal cortex, the ventromedial prefrontal cortex (VMPFC) is, in fact, among the suspects in the colossal global economic implosion that has recently rocked the globe.The VMPFC turns out to be a central location for what economists call “money illusion.” The illusion occurs when people ignore obvious information about the distorting effects of inflation on a purchase and, in an irrational leap, decide that the thing is worth much more than it really is. Money illusion may convince prospective buyers that a house is always a great investment because of the misbegotten perception that prices inexorably rise. Robert J. Shiller, a professor of economics at Yale University, contends that the faulty logic of money illusion contributed to the housing bubble: “Since people are likely to remember the price they paid for their house from many years ago but remember few other prices from then, they have the mistaken impression that home prices have gone up more than other prices, giving a mistakenly exaggerated impression of the investment potential of houses.”
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Runner-ups:
- Over-the-Counter Derivatives: Modernizing Oversight
- The 7 Habits of Highly Suspicious Hedge Funds
Related posts from the blog:
- Article of the week (22/2009): Rising Interest Rates Finally Start to Matter
- Article of the week (23/2009): The Crisis and How to Deal with It
- Article of the week (14/2009): My Manhattan Project
- Article of the week (18/2009): Geithner, Member and Overseer of Finance Club
- Article of the week (13/2009): The Big Takeover
