What I thought I'd talk about today is the Austrian business cycle theory and the mind
of the investor.
And anybody who follows financial markets has to wonder at times, what are these people
thinking?
I mean, how did they come to make the decisions that they're making?
I mean, it's hard to imagine that John Mooth and Robert Lucas came up with what's known
as the rational expectations theory.
And that's explained by Wikipedia as it is assumed that the outcomes that are being forecast
do not systematically differ from market equilibrium results.
That is, it assumes that people do not make systematic errors when predicting the future,
and deviations from perfect foresight are only random.
Now Muth and Lucas should, I think they should watch some daily programs on the financial
channel like Jim Cramer's Mad Money, which is supposedly to help individual investors,
or CNBC's Fast Money, which is clearly geared towards speculators.
And I was even able to catch a little bit of options action on CNBC last evening.
I don't think any viewer can watch these shows and walk away believing that people do not
make systematic errors when predicting the future.
So while financial markets have been in a series of speculative bubbles as the Federal
Reserve creates money ad infinitum, rational expectations economists Robert Flood and Robert
Hodrick daringly conclude the current empirical tests for bubbles do not successfully establish
to establish the case that bubbles exist in asset prices.
Of course, the efficient markets hypothesis is the rational expectations school of the investment world.
Efficient market hypothesis asserts that financial markets are informationally efficient,
claiming one cannot consistently achieve returns in excess of the average market returns on a risk-adjusted basis.
Bob Murphy wrote recently on Mises Org about Chicago economist Eugene Fama, who is the father, I knew I was going to say farmer,
Farmer, the father of Efficient Markets Hypothesis. Fama is not a Nobel Laureate, but he did
co-author the Theory of Finance textbook with Nobel winner Merton Miller. And he himself
won the 2005 Deutsche Bank Prize in Financial Economics, as well as the 2008 Morgan Stanley
American Finance Association Award.
Now, Fama was interviewed by The New Yorker's John Cassidy, and that was the basis for Bob
Murphy's article, and Cassidy asked Fama how he thought the efficient markets hypothesis
had held up during the recent multiple financial crisis.
Fama said, I think it did quite well during this episode.
started to decline in advance of when people recognized that there was a recession, and
then continued to decline.
There was nothing unusual about that.
That was exactly what you would expect if markets were efficient.
Now when Cassidy pressed him a little bit and mentioned the credit bubble that led to
the housing bubble and the eventual bust, the professor said, I don't even know what
that means.
People who get credit have to get it from somewhere.
Does that mean a credit bubble means that people were saving excessively during this period?
I don't know what a credit bubble means.
I don't even know what a bubble means.
These are words that have become popular, but I don't think they have any meaning.
I think most bubbles are 20-20 hindsight, Fama told Cassidy.
And when asked to clarify whether he thought bubbles can exist at all,
And at all, Fama answered, they, or bubbles, have to be predictable phenomenon.
Now I don't know what Professor Fama's been smoking or whether he's just in denial or
not paying attention, but ever since Richard Nixon cut the dollar loose from gold, it's
been one bubble and bust after another.
And clearly in a bubble, in a boom, people go crazy.
Another term for bubble is mania, and according to Webster's mania is referred to in an individual
as excitement of psychotic proportions manifested by mental and physical hyperactivity, disorganization
of behavior, and elevation of mood.
I think that pretty much describes what goes on here in Manhattan every day, probably.
Robert Prechter points out that mania refers specifically to the manic phase of manic depressive
psychosis.
So when we go turn to what neurologists say about all this, Reid Montane did some studies
with two economists to study the effects of booms and busts in a market simulation.
In this study, each of the participants were given $100 to invest, and they made their
decisions against 20 different markets.
The two economists used historical market prices, and they measured brain and behavioral
The researchers were especially interested in how subjects would respond to markets featuring bubbles and crashes.
Subjects' brains were scanned while they created and reacted to market bubbles and their investments.
52 subjects participated in the investment game in the scanners, but had no idea that they were actually playing in actual historical markets.
The two of the markets that were used were particularly brutal on the 52 participants.
One was the 1987 crash, as you would expect, and the other was the 1929 crash.
None of the subjects earned money in the 1929 crash and most lost more than 50% of their portfolio.
This market, Reed Montague explains, out of all 20 used lullabied or lulled subjects' decision mechanisms into a kind of stupor and then bang, goodbye money.
The variable that most drove behavior in the investment game in all markets was regret.
Regret was a big factor when subjects changed their investments and also showed up as an extremely strong neural signal in the reward decision-making region in the brain.
The ventral pituma, the site where reward prediction error signals appear.
Now, Montague believes that this is significant because as gambling games evolved to exploit the frailties of our biological valuation and decision-making machinery, the 1929 market hit kind of a fragile sweet spot of valuation and decision machinery in the subject's brain.
Now regret in this case is the difference between the value of what is and the value of what could have been.
And this is important because of something called dopamine,
which is a chemical in the brain that helps humans decide how to take actions that will result in rewards at the right time.
Now people don't get a dopamine kick when they get what they expect, only when they have an unexpected windfall.
So, as Jason Zweig writes, drug addicts crave ever larger fixes to achieve the same satisfaction,
and that's why investors have such a hankering for fast rising stocks with positive momentum
and accelerating earnings growth.
Also dopamine dries up if the reward you expect fails to materialize.
So the brain has 100 billion neurons and only one twentieth of one percent produce dopamine,
but this minuscule neural minority wields enormous power in your investment decisions.
Dopamine takes about a twentieth of a second to reach your decision centers, estimating
the value of an expected reward and more importantly propelling you to action to capture that award.
We've evolved to be that way by being, because passively knowing about the future is just
not good enough.
The effect of all this is what Jason Zweig refers to as the prediction addiction.
Humans hate randomness, we want to predict the unpredictable, which originates in the
dopamine centers of the reflective brain.
And according to Zweig, this leads humans to see patterns where none really exist.
Now, the whole technical analysis field in Wall Street embraces all this, and it's based
on the human desire to predict, and when seeing two occurrences occur in repetition, people
believe or want to believe that a trend is in place, and most importantly, it's a trend
that they can profit from.
When Parkinson's patients are given drugs to allow their brains to be more receptive
to Dopamine. They have an insatiable urge to gamble. When these drugs are stopped, the
gambling stops immediately, but unfortunately when they get what they expect, no dopamine
rush occurs. Now, these neurologists don't talk about Austrian Business Cycle Theory.
For that, we turn to Ludwig von Mises, who explains that when the central bank lowers
There's interest rates below the natural rate of interest engineered by an increase in liquidity.
These low rates, as he writes, falsifies the businessman's calculation.
The result of such calculations is therefore misleading.
They make some projects appear profitable and realizable, which a correct calculation
based on an interest rate not manipulated by credit expansion would have shown as unrealizable.
Entrepreneurs embark on the execution of such projects, a boom begins, Mises writes.
Now computational neuroscientists would add that not only do the projects appear profitable
on paper, but also that dopamine is released into the brains as entrepreneurs anticipate
future profits.
After all, it's ingrained in the collective brains of business and investing public everywhere
that if interest rates are lowered on the short-term basis and eventually on the long-term
basis, all things great will happen with the economy. Low interest rates will stimulate
business investment by making more investment projects profitable. Reduced interest costs
mean that more machines will be built, more equipment will be bought, new factories and
warehouses will be built, additional stores and apartment buildings open. Businesses may
also increase production because of lower cost of financing, fall in interest peps up
investment in production. It also means that investors will move out of interest bearing
Investments like bank CDs and bonds and into riskier investments like stocks, thus causing
a stock market rally.
And that's for this reason that the stock market generally believes that a lowering
of interest rates is positive for the market and it'll cause a stock market rally.
Higher stock prices, of course, make it easier for business to issue more stocks and finance
additional investment.
As Mises wrote in a book called On the Manipulation of Money and Credit, the moderated interest
rate is intended to stimulate production and not to cause a stock market boom.
However, stock prices increase first of all.
At the outset, commodity prices are not caught in the boom, they are stock exchange booms
and stock exchange profits, yet the producer is dissatisfied.
He envies the speculator for his easy profit. Those in power are not willing to accept this
situation. They believe that production is being deprived of the money which is flowing
into the stock market. Besides, it is precisely in the stock market boom that the serious
threat of a crisis lies hidden.
So the excess liquidity created by the central bank ends up being invested in stocks as the
The price of these stocks rise, investors' dopamine levels increase from the expectation
of the gain. Riskier stocks are then bid up in price by investors because more risk must
be undertaken to achieve the same dopamine rush and a market becomes a bubble.
Now the modern world of financial markets is one long series of unending booms and busts,
But the investing public falls for it every single time.
Rates are going down, the economy will get better, stocks are going up, real estate is
going up, I better pile in, I don't want to miss the boat, I don't want to regret not
getting in on the action.
What is it that can explain this group think?
Solomon Asch's work on conformity demonstrates that groupthink is extremely powerful.
His experiments show that people influenced by a crowd will knowingly make the wrong decision
seventy percent of the time, just to go along with the crowd.
Emory University neuroscientist Gregory Burns found that people who broke ranks with a conforming
and Group, areas of their brain lit up that are associated with negative emotions.
In other words, nonconformity is an emotionally traumatic experience, which is why most of
us don't like to break ranks with our social groups.
It's hard to be a contrarian.
I mean, when the bubble is in full bloom, the last thing you want to tell your friends
Friends at the club, you don't want to tell your friends here at the university club,
gee, I'm in cash and gold.
I mean, they'll make fun of you.
They're going to go, wow, we're in stocks, we're in real estate, what's the matter with
you?
You're a wimp.
Come on, this is easy.
We're cleaning up.
You're going to regret it if you don't, and then of course you go home, your spouse starts
in on you.
How are our stocks doing, honey? When are we going to pick up some rental properties, like the Joneses next door?
So group think studies show even that good people can do bad things.
That evil is facilitated through the contagious excitement of a group's action,
and the unchecked momentum of smaller bad steps that come before and ultimately permission for evil is granted by the system at large.
So by the same token, level-headed investors can and have been caught up in investment booms and manias.
Even the best investors can lose their heads.
So if stock market is going up, people pile in, and there's even a name for it.
It's called momentum investing.
Of course, ultimately the fundamentals of the investments do not support the prices.
Market prices cool, dopamine levels dry up, and as expected gains don't materialize,
a crash ensues with investor regret.
The booms end in tears. The ultimate bust makes people despondent and dispirited, Mises wrote.
He goes on, the more optimistic they were under the illusory prosperity of the boom,
the greater is their despair and their feeling of frustration. The individual is always ready
to ascribe his good luck to his own efficiency and to take as a well-deserved reward for his talent, application, and probity.
But reverses a fortune, he always charges to other people, and most of all to the absurdity of social and political institutions.
He does not blame the authorities for having fostered the boom, he reviles them for the inevitable collapse.
Now the rationalization that Mises refers to is discussed by psychologist Daniel Gilbert,
who explains that our frontal lobes make us look at ourselves through rose-colored glasses.
To learn from our experience, we must remember it, and for a variety of reasons, memory is a faithless friend.
Psychologists call this hindsight bias. People distort and misremember what they formerly believed.
Our sense of how uncertain the world really is never fully develops.
Because after something happens, we greatly increase our judgments of how likely it was to happen in the first place.
This bias keeps us feeling like, keeps us from feeling like idiots as we look back, but unfortunately it can make us act like the idiots going forward.
Now the phenomenon of cognitive dissonance is another way to look at this.
Cognitive dissonance is the mental tension created when a person holds two conflicting thoughts simultaneously.
For instance, an investor probably felt like they were going to invest during the boom and get rich and when that doesn't work out and the bust occurs or when the stocks go south for some other reason, obviously the investor was wrong, but will the investor admit it?
No. The investor will frequently emerge, not only unshaken, but even show a new fervor about convincing and converting people to his or her view.
As we hang on to losing stocks, unprofitable investments, failing businesses, unsuccessful relationships, we're experiencing cognitive dissonance, rationalizing our past choices.
while, unfortunately, these rationalizations influence our present ones.
There is a need to stress this point, wrote Mises,
because the public, always in search of a scapegoat,
is, as a rule, ready to blame the monetary authorities and the banks for the outbreak of the crisis.
They are guilty, it is asserted,
Because in stopping the further expansion of credit, they have produced a deflationary pressure on trade.
Well, the fact is, for most people, we just don't have the brain suitable for investing.
Humans have too many biases, biases that protect us and our fragile egos,
so that we can get up and face life each and every day.
But in a world of fiat currencies, created with the ease of a p-stroke, the value of our savings is threatened every hour of every day.
And when monetary bureaucrats act to send shockwaves, not only through financial markets, but they send shockwaves through investors' and entrepreneurs' brains,
Sending the mass to invest it on yet another chase toward riches that are but a chimera.
The spiritual dimension of these inflation-induced habits seem obvious,
Guido Holzman wrote in a wonderful book, The Ethics of Money Production.
Money and financial questions come to play an exaggerated role in the life of man.
But for ordinary citizens to simply put money in a savings account at a local bank is suicidal, as Holzman makes clear.
They must invest in assets, the value of which grows during inflation.
The most practical way to do this is to buy stocks and bonds, he writes.
But this entails many hours spent on comparing and selecting appropriate issues.
and it compels them to be ever watchful and concerned about their money for the rest of their lives.
They need to follow the financial news and monitor the price quotations on financial markets.
Well, the rational expectations school and the efficient markets hypothesis folks thinks that that's all just fine.
After all, everyone is perfectly rational and have all the information they need to invest without worry.
don't worry. They say market bubbles and the ensuing crashes just aren't possible. According
to the rational expectation school, investors know what markets are going to do, when they're
going to do it, how much they're going to go up, how much they're going to go down.
But those of us in the Austrian school, we know better. Booms and busts do happen with
with all too much regularity in a fiat money world, inflicting not only financial pain, but emotional and social turmoil as well.
Professor Holzman points out that carpenters, masons, tailors, and farmers are usually not very astute observers of the international capital markets.
Putting some gold coins under their mattress or in a safe deposit box saved them many a sleepless night
and made them independent of financial intermediaries.
I think the way the market is today, that's good advice for all of us. Thank you.