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|I Am Skooter|
So here's us, on the raggedy edge.
Janice Gross Stein is more commonly a foreign affairs correspondent, but has an interesting article in the Literary Review of Canada titled Between Euphoria and Fear that looks at the financial meltdown and the role that emotion played in perpetuating it. Essentially, basic economic theory should have suggested that the market would “correct” itself as investors behaved rationally. This didn’t seem to happen, and behaviour was far from rational.
To complicate matters further, pioneering new research in neuroscience in the last 15 years by Antonio Damasio and Joseph LeDoux, among others, demonstrates that emotion is primary and plays a dominant role in choice because it is automatic and fast. Damasio was able to observe closely patients who had suffered injury to those parts of the brain that process emotions, and, to his surprise, his patients were unable to make even simple rational choices even though their cognitive systems were fully intact. Rationality, he demonstrated in his clinical research, requires emotion.
The problematic behaviour happened, basically, when people lost money and feared losing more money. The money that was then withdrawn created a market contraction. Rationally, people should have taken the long view and left their money in there. There was a problem with this though:
Mainstream economics treats risk as judgements about variation over outcomes, judgements that are informed by probability theory. Psychologists see it differently. The propensity to take risk is in part determined by whether people have gained or lost in relation to some reference point.
People didn’t care if they had more money than they’d invested a few years ago: the face that they were still “up” didn’t matter—they were “down” relative to their mental reference point.