We were supposed to be living in a rational world. According to neoclassical economics, people are "rational agents" who logically assess their own best interests and then act accordingly. Like cogs in a Swiss watch, their behavior can be predicted and modeled.
Thanks to the world's ongoing economic paroxysms that view has largely gone out the window. Since 2007, everyone - investors, consumers, management- has seemingly jumped from panic to euphoria and now back to panic again. The economy not as a mathematical system so much as a collective madness.
John Coates is a uniquely well positioned to understand what's going on. He spent 12 years as a trader in London and New York, working first for Goldman Sachs and then Deutsche Bank. What he saw in real life was totally at odds with economic theory. "It was the dot com bubble," he recalls. "People had classic, clinical symptoms of mania. They were delusional, euphoric, over-confident - you couldn't get them to shut up."
Most traders worth their salt would have figured out how to turn this insight into a a play that would make them a killing on the market. But Coates wasn't that guy. Instead of stoking his greed, it fueled his curiosity. He wondered: how does what physically goes on inside the brain and body affect the market's ups and downs? So Coates ditched Wall Street, went back to school, and wound up a research professor in Cambridge University's neuroscience department.Then, armed with scientific apparatus, he went back to the trading floor. He measured the hormone levels of professional traders as they went about their business, buying and selling. And what he found gave him a surprising insight.
It turned out that traders with high levels of testosterone in the morning tended to make more money during the course of the day. This was counter-intuitive, because while sports physiologists had long been known that after a game winners experience a surge of testosterone, Coates found that the successful traders' testosterone went up before they made their killings. What he was seeing, Coates guessed, was a variant of the so-called Winner's Effect: when a victor's testosterone surge jolts his confidence and risk-taking, it gives him a better chance of winning the next time. Success breeds success. In an upward market, everyone wins, everyone's testosterone goes up, everyone bets more and more aggressively. Dow 36,000!
Coates' data also hinted at how things can go wrong in the other direction. He found that when the market was particularly volatile, traders' bloodstreams were spiked with a stress hormone called cortisol. "Cortisol affects the memories you recall. And it tends to make you recall mostly negative precedents. You generally see danger everywhere," Coates says. "That makes you very risk averse."
Here's the thing: there's no way to tell, without taking a chemical measurement, how high your cortisol or testosterone levels are. You can't feel the effects. But the results on your behavior are measurable. "You could give the same set of facts to two people, and one who was ripped on testosterone would see nothing but opportunity, while another person who's got chronically elevated cortisol levels will see nothing but risk," says Coates. Testosterone doesn't cause bubbles, then, but it might exaggerate a bull market and turn it into a bubble. And cortisol might exaggerate a bear market and turn it into a crash.
Of course, Wall Street isn't the only place gripped by fear. It's everywhere. While many indicators show that the economy has been rebounding, consumer confidence remains low. Anxiety is everywhere. And that's bad news, hormonally, for all of us. While cortisol is useful for helping the body respond to stress in the short term, if levels are elevated for too long it can be downright toxic, leading to high blood pressure, decreased cognitive functioning, and a suppressed immune system.
People are still worried about losing their jobs, and that's a major source of stress. Sarah Burgard, an assistant professor of sociology at the University of Michigan, recently compared the physical and mental health of 3,000 workers and found that those who felt their jobs were in danger were in significantly poorer health than those who weren't worried. Astoundingly, they were in worse shape than people who'd actually gone through the short, sharp shock of actually losing their jobs. "The stress response was designed for acute responses, like running away from lions, not for long term job insecurity," Burgard says.
Now that we're all in a collective freefall, that's good to know. Chances are high that our worsening financial crisis will lead to both economic and psychological depression. But that, paradoxically, might ultimately be our salvation. Numerous studies have shown that sad or depressed people tend to think more carefully, to make more accurate decisions, and to take stock of their situation more realistically. So maybe all this bad economic news will wind up bringing us the rationality we need.