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The psychology behind boom and bust

Dramatic physical reactions to making and losing money help fuel our economy's big gains and huge losses.

May 17, 2009|Doyle McManus

To all the explanations of how the economy crashed last year, add one more: Investors' judgment was clouded because they were high -- on profits.

"Financial gain actually has some of the same effect on your brain as cocaine," says Andrew W. Lo, an economist at the Massachusetts Institute of Technology. "You're in a kind of stupor; you're feeling no pain."

He's not kidding. To quote one of his papers: "The same neural circuitry that responds to cocaine, food and sex -- the mesolimbic dopamine reward system that releases dopamine in the nucleus accumbens -- has been shown to be activated by monetary gain as well."

There were plenty of reasons for last year's financial meltdown, Lo says, but at least one of them was psychological: A long financial boom "breeds an atmosphere of risk tolerance and complacency." That's why financiers and other investors made excessively risky bets -- they thought they couldn't lose.

And now? The same problem in reverse. Investors' judgment is clouded by all the pain they feel.

"Now we've had this very traumatic event; fear has kicked in, as opposed to greed," Lo said. In a financial panic, he said, adrenaline and cortisol flow into the bloodstream, just as in any other state of fear. In the aftermath of panic, bummed-out investors behave more cautiously -- and that slows the pace of economic recovery.

"We are going to be in a period of decreased risk tolerance," he said. "We'll overreact. We'll end up contracting more than we need to."

To estimate how long that will take, Lo switched metaphors -- to the five stages of grief theorized by psychiatrist Elisabeth Kubler-Ross. "Financial loss can be as traumatic as terminal illness," he said. "We're somewhere between stages three and four, between bargaining and depression -- emotional depression, not financial depression. We're not going to recover until we get to acceptance. We have to accept the fundamental reality that we can't live in a leveraged state. I think we have another six to nine months before we see a genuine recovery."

That may sound a little New Age-y compared with the supply-and-demand stuff you learned in college. But Lo is only one member of a growing caucus of respected behavioral economists who argue that psychology's impact on the economy isn't a blip, it's a real factor that can help inflate a financial bubble -- and, after the bubble bursts, delay a recovery.

Most behavioral economists don't rely on dopamine, but the underlying point is the same. Humans control the economy, and humans aren't purely rational beings. They have emotions, mood swings and hormones, and those non-rational factors affect their economic decisions, from splurging on lattes to reducing interest rates at the Federal Reserve.

During the real estate boom, consumer spending was boosted by the "wealth effect." Homeowners thought they had money to burn because their houses had risen sharply in value. Now that phenomenon has turned upside down like a bad mortgage. Instead of a wealth effect, we're embracing a "new frugality." Both rich and poor say they are cutting back. Spending at luxury stores has plunged; spending at Wal-Mart is up. If we were hoping for a recovery led by consumption, that's going to take a while.

The good news is that Americans, stung by the results of their profligacy, are saving again. Last year, the national savings rate -- the percentage of income that Americans didn't spend -- dropped below zero; as a nation, we were borrowing money to buy stuff. This year, for three months in a row, the savings rate has edged up above 4%, and economists expect baby boomers -- anxious about their depleted retirement accounts -- to push it over 6%.

More saving is good for the economy in the long run because it means more capital to invest in growing businesses. But the way people invest is likely to change too, and for the same reason spending habits have changed: Once burned, twice shy.

This year's savers are more likely to put money into investments that feel safe -- Treasury bills, bonds and insured accounts. In a survey of people with net worth over $1 million, half said they have become more risk-averse. "The continuing economic turmoil has stripped America's millionaires of their confidence," said Walter H. Zultowski of the Phoenix Cos., which sponsored the poll. For an entrepreneurial nation, it's serious trouble when a crisis robs our millionaires of their moxie.

And if history is any guide, that effect could last a while. The Depression generation that grew up in the 1930s remained wary of the stock market for the rest of their lives; young adults who just saw their 401(k)s tank may follow the same pattern.

"There's still a lot of uncertainty, and fear of the unknown is the strongest kind of fear there is," Lo said.

What's the solution? There's no quick fix, but -- speaking of drugs -- here's where the most sleep-inducing part of President Obama's economic agenda comes in: regulatory reform.

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