Finance in the 21st Century
The Neuroeconomics Revolution
Robert J. Shiller
|
|
|
|
NEW HAVEN – Economics is at the start of a revolution that is traceable to an unexpected source: medical schools and their research facilities. Neuroscience – the science of how the brain, that physical organ inside one’s head, really works – is beginning to change the way we think about how people make decisions. These findings will inevitably change the way we think about how economies function. In short, we are at the dawn of “neuroeconomics.”
Efforts to link neuroscience to economics have occurred mostly in just the last few years, and the growth of neuroeconomics is still in its early stages. But its nascence follows a pattern: revolutions in science tend to come from completely unexpected places. A field of science can turn barren if no fundamentally new approaches to research are on the horizon. Scholars can become so trapped in their methods – in the language and assumptions of the accepted approach to their discipline – that their research becomes repetitive or trivial.
Then something exciting comes along from someone who was never involved with these methods – some new idea that attracts young scholars and a few iconoclastic old scholars, who are willing to learn a different science and its different research methods. At a certain moment in this process, a scientific revolution is born.
The neuroeconomic revolution has passed some key milestones quite recently, notably the publication last year of neuroscientist Paul Glimcher’s book Foundations of Neuroeconomic Analysis – a pointed variation on the title of Paul Samuelson’s 1947 classic work, Foundations of Economic Analysis, which helped to launch an earlier revolution in economic theory. And Glimcher himself now holds an appointment at New York University’s economics department (he also works at NYU’s Center for Neural Science).
To most economists, however, Glimcher might as well have come from outer space. After all, his doctorate is from the University of Pennsylvania School of Medicine’s neuroscience department. Moreover, neuroeconomists like him conduct research that is well beyond their conventional colleagues’ intellectual comfort zone, for they seek to advance some of the core concepts of economics by linking them to specific brain structures.
Much of modern economic and financial theory is based on the assumption that people are rational, and thus that they systematically maximize their own happiness, or as economists call it, their “utility.” When Samuelson took on the subject in his 1947 book, he did not look into the brain, but relied instead on “revealed preference.” People’s objectives are revealed only by observing their economic activities. Under Samuelson’s guidance, generations of economists have based their research not on any physical structure underlying thought and behavior, but only on the assumption of rationality.
As a result, Glimcher is skeptical of prevailing economic theory, and is seeking a physical basis for it in the brain. He wants to transform “soft” utility theory into “hard” utility theory by discovering the brain mechanisms that underlie it.
In particular, Glimcher wants to identify brain structures that process key elements of utility theory when people face uncertainty: “(1) subjective value, (2) probability, (3) the product of subjective value and probability (expected subjective value), and (4) a neuro-computational mechanism that selects the element from the choice set that has the highest ‘expected subjective value’…”
While Glimcher and his colleagues have uncovered tantalizing evidence, they have yet to find most of the fundamental brain structures. Maybe that is because such structures simply do not exist, and the whole utility-maximization theory is wrong, or at least in need of fundamental revision. If so, that finding alone would shake economics to its foundations.
Another direction that excites neuroscientists is how the brain deals with ambiguous situations, when probabilities are not known, and when other highly relevant information is not available. It has already been discovered that the brain regions used to deal with problems when probabilities are clear are different from those used when probabilities are unknown. This research might help us to understand how people handle uncertainty and risk in, say, financial markets at a time of crisis.
John Maynard Keynes thought that most economic decision-making occurs in ambiguous situations in which probabilities are not known. He concluded that much of our business cycle is driven by fluctuations in “animal spirits,” something in the mind – and not understood by economists.
Of course, the problem with economics is that there are often as many interpretations of any crisis as there are economists. An economy is a remarkably complex structure, and fathoming it depends on understanding its laws, regulations, business practices and customs, and balance sheets, among many other details.
Yet it is likely that one day we will know much more about how economies work – or fail to work – by understanding better the physical structures that underlie brain functioning. Those structures – networks of neurons that communicate with each other via axons and dendrites – underlie the familiar analogy of the brain to a computer – networks of transistors that communicate with each other via electric wires. The economy is the next analogy: a network of people who communicate with each other via electronic and other connections.
The brain, the computer, and the economy: all three are devices whose purpose is to solve fundamental information problems in coordinating the activities of individual units – the neurons, the transistors, or individual people. As we improve our understanding of the problems that any one of these devices solves – and how it overcomes obstacles in doing so – we learn something valuable about all three.
Robert Shiller, Professor of Economics at Yale University, is co-author, with George Akerlof, of Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.
Copyright: Project Syndicate, 2011.
www.project-syndicate.org
For a podcast of this commentary in English, please use this link:
http://traffic.libsyn.com/projectsyndicate/shiller80.mp3
You might also like to read more from Robert J. Shiller or return to our home page.
|
|
Skeptic 07:23 21 Nov 11
TMM, correcting one of the smartest academics in the history of post-neoclassical economics is pretty bold, but incorrect. A simple Google search for 'animal spirits' should set you straight.
Glad to hear confirmation of a paradigm shift from the top (Shiller). The rationality assumption under which economics has been operating for the past 80 years has been in need of overhaul. If neuroeconomics takes off, reestablishing rationality on an empirical basis will be realistic.
TMMCahal 08:31 21 Nov 11
Skeptic,
Shiller may be one of the smartest academics in the world and he is certainly one of my favourites, but that doesn't mean he is right about everything.
Keynes did not say 'the business cycle is created by irrationality, all we can do is respond to it with fiscal stimulus', despite what many believe. He thought that high interest rates pushed investors into more speculative and risky endeavours, creating inflation and bubbles.
Apologies for a shameless plug, but I don't want to repeat myself too much - I wrote about this here:
http://unlearningeconomics.wordpress.com/2011/11/16/keynes-figured-it-all-out-a-while-ago/
I am deeply critical of neoclassical rationality assumptions, btw, and look forward to the contributions neuroeconomics has to offer.
groovologist 10:15 21 Nov 11
World backstage knows that, and uses they own "media" to manipulate our brain.
groovologist 10:15 21 Nov 11
World backstage knows that and use their own "media" to manipulate our brain.
Zsolt 10:22 21 Nov 11
It is a very interesting and important article as finally we bring seemingly different sciences, areas closer to each other, understanding that we live in a highly interconnected system where all elements interact with each other.
Basically economics are the external manifestation of underlying human connections, how we interact, make relationships with each other beyond the natural family connections, thus they are directly dependent on our internal behaviour.
With all due respect to the scientists involved I am still not certain that by studying the working of our brain cells, neurotransmissions we will get closer to the true process.
Our body, its cells and their function belongs to the animal part in a human, and as any natural living creature the body thrives for homeostasis, and always tries to achieve optimal balance. This is an automatic natural function which cannot explain all the disorder, exploitation, crisis situation we actively build and cause among ourselves and against our environment.
Without applying psychology over the natoral working of the animal body we will never get closer to the true understanding of human behaviour or its external manifestations like economics.
If we behaved like any other animal on this planet we would still be very close to how animals live, undeveloped and at the same time in total harmony with nature.
What differentiates us from animals is our human ego, which pushes us towards the "utility" the article mentions, to always calculate and thrive for the maximum benefit for ourselves disconnected from the harmonious natural process and balance.
This driving force fuelled the whole human evolution and history, and finally brought us to the present cross road, where the maximally developed ego has become totally opposite and deadlocked with the natural interconnected and interdependent system. We experience this state as the global crisis.
The task in front of us is how to override this human ego and return to the natural balance we left long time ago. This can only be achieved with a higher function, purpose, similar to the "Superego" concept from Freud, when instead of automatically obeying our own egoistic desires we rise above them accepting on ourselves some higher concept, like the general homeostasis of the system we live in, accepting we are part of a network where we have to function for the network's optimal state above our individual interest.
For this we have to first of all accept that humanity is just an element in the natural system around us, and then take upon ourselves the overall direction for balance and harmony within the system by creating harmony within humanity. The motivation for this is the understanding that in this highly interconnected and interdependent network any individual element can only succeed and survie if the whole system functions optimally.
At the end we could say we return to be a "balanced, harmonious animal" as we used to be, except this time we do this consciously, by free choice, which conscious action makes us truly human, the creature that overcome itself to return to harmony.
Neuroscience can help us understand how a complex system thrives and achieves harmony, thus keeping it as an ideal goal we can make the transition from the "utility" chasing state to the ideal balanced state. But this can only work if we interpolate this process out of the individual to a common interconnected plane, not only taking into account how individual brains work, but how individual brains can connect together into a mutual network, in order to achieve the hoped result. This is beyond what classical neuroscience can offer today.
The new social and economical system we have to build today have to reflect this process.
crdcalusa 11:55 21 Nov 11
The utility theory regarding reactions of people facing uncertainty is based on subjective reality as are all the economic systems on record so far. We base economic systems on repeated patterns of known behavior that exist and then build it from this platform. We include concepts such as consumer theory and make an attempt at including known variables. I can see two problems with this. One is the fact that the variables within any patern of economics are always changing and analyzing the reason for those changes is impossible from within a static conception. The second problem is that instead of analyzing existing patterns we should be chosing an agreed upon optimal outcome as the base and then analyzing how we reach that outcome. What does it take to stimulate cooperation and preservation of our species and what are the neurodynamics of altruism and how can we encourage that state. We already know where our self preservation capacities are taking us and how they affect economic systems. This is a new day. Mankind is developing past these old models. New systems should analyze and exploit capacities for cooperation and pleasure derived from acheving mutual benefits and shared concerns.
engineer_sci 06:30 22 Nov 11
I seem to have a similar sense of the matter as the authors of the previous two comments. It seems to me that there is a very exciting possibility here, of taking the battleground to save the world economy right to the economic atom itself -- the individual human mind.
Can we use our understanding of the interdependent global reality to overcome simple gut animal instincts for self-gratification, and develop the enlighted self-interest of true altruism. This new neuroeconomic science might offer -- even if never a practical tool set -- at least a strong theoretical indicator that the battle to save our external civilization will find its true battle front not on Wall Street, the pallor rooms of Europe, or the production drivers of China -- but in the private war within each of us. Individually, such a war against our own nature may well be lost from the start. But perhaps the very same social pressure -- the need for status and respect -- that have driven us to such harm in the past can be harnassed at this late stage for a great good.
rameshraghuvanshi 05:12 22 Nov 11
Without taking help of psychoanylisis how can we find out meaning moving here and there of our nutrons?Watching scaning of brain we can only findout is thereis damage in brain or not.but for to search a meaning of movement of nutrons we must taske help of psycholohy.That why many neuroscientiast taking help of Freud
lukelea 09:30 22 Nov 11
"He wants to transform “soft” utility theory into “hard” utility theory by discovering the brain mechanisms that underlie it. In particular, Glimcher wants to identify brain structures that process key elements of utility theory when people face uncertainty: “(1) subjective value, (2) probability, (3) the product of subjective value and probability (expected subjective value), and (4) a neuro-computational mechanism that selects the element from the choice set that has the highest ‘expected subjective value’…”
I believe Keynes examines these issues and had some useful things to say in his book on Probability, to which he devoted more time than to anything else in his career. Also, Bentham, surprisingly, in the opening chapters of his Theory of Morals makes some very useful observations. You don't have to be a brain scientist to know which way the wind blows . . .
lukelea 09:30 22 Nov 11
"He wants to transform “soft” utility theory into “hard” utility theory by discovering the brain mechanisms that underlie it. In particular, Glimcher wants to identify brain structures that process key elements of utility theory when people face uncertainty: “(1) subjective value, (2) probability, (3) the product of subjective value and probability (expected subjective value), and (4) a neuro-computational mechanism that selects the element from the choice set that has the highest ‘expected subjective value’…”
I believe Keynes examines these issues and had some useful things to say in his book on Probability, to which he devoted more time than to anything else in his career. Also, Bentham, surprisingly, in the opening chapters of his Theory of Morals makes some very useful observations. You don't have to be a brain scientist to know which way the wind blows . . .
21tiger 04:37 23 Nov 11
@TMM
Really?
http://en.wikipedia.org/wiki/Animal_spirits_(Keynes).
Whereas classical economists believed the laissez faire approach would lead to quick corrections in the market (good and bad), Keynes believed Human Spirits would actually cause the market fluctuations to be exascerbated, and thus, the goverment just step in and normalize them.. by regulating the interest rates up in over heating bull markets and down in bearish markets---the ideal being a much flatter business cycle (%GDP/econ growth line over time).
This is why 'lefties' believe in more Government intervention, and 'righties' believe is less (or none--or no government at all in some cases).
*shrug* It seems to work out, but I'm not too sure.
Alamanach 06:40 23 Nov 11
I haven't seen the actual research, but at first glance, I'm skeptical. So far as an individual is concerned, there's not a dime's worth of difference between economic decision making and decision making in other aspects of life. If neuroscience is advanced enough that it can trace the physical mechanisms behind our decisions, then why limit this to economics? Why not politics? Why not game theory? Why not favored flavors of ice cream? Why not love? If we can trace out the neuromechanisms of economics, then that knowledge should apply just as well to these other things. But neuroscience cannot do these things. If it could, we would have built computer capable of passing the Turing Test by now.
TMMCahal 02:25 23 Nov 11
'Whereas classical economists believed the laissez faire approach would lead to quick corrections in the market (good and bad), Keynes believed Human Spirits would actually cause the market fluctuations to be exascerbated, and thus, the goverment just step in and normalize them..'
He *did* use the phrase but it wasn't massively significant to his theory in the way you describe. He thought the rate of interest was determined by psychological factors - whether investors wanted to hold cash in the face of uncertainty instead of buying bonds - and hence would be too high. Thus the authorities needed to keep long term borrowing rates permanently low. To approximate full employment.
'by regulating the interest rates up in over heating bull markets and down in bearish markets---the ideal being a much flatter business cycle (%GDP/econ growth line over time).'
This was never true - he completely opposed demand management. Check the bank of england base rate in the 1930s - he got them to fix it at 2% and not change it for a long time.
Fred 02:58 24 Nov 11
George Goodman, aka Adam Smith in The Money Game, 50 years ago described the market as you can take a bunch of individually rational men and put them into a crowd that, in turn, will behave as an irrational woman. Simply put, the whole is not a linear sum of its parts. It is the interaction of the parts that makes up the whole. You cannot sum up a bunch of microeconomic models in order to understand macroeconomics. That is why they are two separate branches of economics. The psychology of an individual does not really help you to understand the social psychology (behavior) of groups. The major problem with behavioral finance is that it tries to study the individual psychology of an investor and then extrapolates the behavior of the market from summing up the behavior of the individuals. Physics does not have a unified theory. It is kind of presumptious to think we do.
nadoka 12:18 24 Nov 11
It is good that a medical speciality, particularly in this case one that adds scientific rigor to the mechanisms of the human brain, is examining how the internal mechanisms work in concert to effect complex external responses to value creation and manipulation.
What surprises me is that the unified notion of economic utiility through "rational choice" has held water for such a very long time. Even the most cursory observations of external traits of the human reveals an immense difference in how we appear, how our speech patterns are so varied, how our individual reactions to almost every stimuli range greatly, where we find pleasure and what we consider discomfort, and so on. Economics, in ignoring this complexity, imaybe a long running and simplistic fraud... perhaps more akin to a Ponzi Scheme.
lukelea 04:59 24 Nov 11
re: the brain and economics, there is decision theory and there is the law of diminishing returns. The latter, I speculate, reduces to the depletion of neuro-transmitters repeatedly firing under any given stimulus, which must ultimatley come down to issues of chemistry and metabolism.
When applied to the increasing disutility of labor (ie, fatigue) we would be dealing, I think, with a slightly different aspect of chemistry. As an extreme case imagine there were no increasing marginal disutility of labor: Usain Bolt could run a marathon at full sprint speed the whole way. There are issues of depletion here, it seems likely, similar to the first example above, only involved with muscle cells instead of neurons.
Consider however the law of diminishing returns applied to the production function of land, labor, and capital. Lets take the extreme case of how much food you could grow in a flower pot with additions of fertilizer. If there were no diminishing returns you could theoretically feed the world. In reality this doesn't happen because of the molecular structure of soil and fertilizers. If nothing else there must come a point when every molecule of soil is completely enveloped by molecules of fertilizer, after which the laws of geometry, in this case three-dimensional objects in solid geometry, sets an upper bound.
Aristotle (was he first?)would have referred to the impenetrability of matter at this point; a modern physicist to the fact that fermions cannot be in the same place (state) at the same time. Unlike photons, atoms don't collapse because of the Heisenberg Uncertainty Principle combined with Pauli Exclusion Principle. (I believe similar considerations would ultimately come into play if we carried the physiological limits described in the first two cases above.)
As a last case consider the question of applying more and more units of labor to a fixed amount of capital and raw materials. If one man can build a house in a year, two men should be able to build it in six months (or a little less if their are economies of scale, as when you need someone to hold the other end of the board). Continuing the sequece, 4 men could build the same house in 3 months, etc., until you finally reach the absurd conclusion that 10,000 men, say, could build it in less than a minute. The series brakes down ultimately because too many workers start to get in each others way on a limited building site -- ie, the same problem of impenetrability we encountered before.
Bottom line: issues of geometry and impenetrability (Heisenberg and Pauli) are the utlimate explanations. But Heisenberg's and Pauli's principles are also a function oft geometry (space), so it all comes down to solid geometry and the axioms of quantum mechanics.
I feel sure this analysis is of no practical value but at least it shows the physics and geometry which ultimately govern economic problems. That much is science. So are the convexity of supply and demand curves, which follow; whatever conclusions you can derive from such convexity plus whatever decision theories you construct (which will be functions of information) set the theoretical foundations of neuro-economics. in my humble layman's opinion.
lukelea 05:15 24 Nov 11
Incidentally, if to my foregoing analysis you add an axiom of equality (that all else equal a dollar is always worth more to a poor man than a rich one) you might be able to derive a very crude welfare economics which is consistent with The Declaration of Independence. That would be a moral not an empirical axiom it goes without saying.
Alamanach 05:19 24 Nov 11
@lukelea: "That much is science." Most of what you said was speculation. It was informed, and as speculation goes it was good, but speculation all the same. Diminishing returns might be represented as dwindling amounts of neurotransmitters, but then again they may not. There are synapses, for example, in which one neuron inhibits another from firing, with the result that a third neuron receives no signal. As returns diminish, some inhibitory signal may get stronger and stronger, until ultimately it blocks a signal completely. Such neural systems exist.
Now, that is speculation too. If we cared to, either one of us could dream up yet more neural mechanisms for responding to diminishing returns. Neuroscience as it stands today has identified many configurations of neurons. What we need is the actual mechanism that really does the job. What neuroscience hasn't been able to model is human consciousness-- the sort that goes into utility-maximizing decision-making. In fact, AI researchers have hit upon some very worrying limits involving Godel's Theorem which, to some, suggest that human consciousness cannot be physically modelled. This is odd since, after all, we can model the behavior of each individual neuron. But mathematically, it is formally impossible to model the whole.
We are still working out things like rodent visual systems and feline orienting behavior. We are a long, long way from understanding how people make the decisions that they do.
janvlcek 07:24 25 Nov 11
The analysis should be short-term rational actions when they are also long-term irrational.
Not unlike drug use, or even violating speeding laws in ones auto.
Have a think on that. Explains current economic situations pretty well, including institutional and political positions world-wide.
PACman 04:28 26 Nov 11
Truly, an intellectual fad if ever there was one. The cognitivist paradigm, trying to reduce our brain and behaviour, reflects the dream of perfect understanding and control of human behavior. But we live in a reflexive world of billions of conscious individuals, always adapting to an every-evolving and changing guesses about each other's behaviours. As soon as we have one theory, another will incorporate ity and out-compete it. George Soros eloquently expresses this is this major philosophical works, before, during and after his business career. But good luck with that...
kokobell616 12:44 27 Nov 11
I find the idea of brain mechanics as indicators of economic behaviour to be a bit over the top. The astounding complexity of individual thinking is at the core of discion making not machanics. The myiad of information computed by ones brain is collated and indexed differently for every person thereby signifing differing avenues of thought to arive at a discion. Without significant reason to believe that thought processes align with common attributes. How will research into brain mechanics improve economic theory?
Openmind 05:57 30 Nov 11
I just have published an post in our community of knowledge OpenMind. We invite you to enter OpenMind and share your specialized content with the rest of users http://www.bbvaopenmind.com
Julian_Raphael 03:58 05 Dec 11
I find it interesting how such intelligent people just start to understand this now, when both the economy and the computer are devices which have sprung from the human brain. The economy and the computer are simply means the human race has developed in an evolutionary process to enhance brain to brain communication and as such they are nothing but tools of the single and the collective brain.While I see the analogy between computer and brain, I fail to see how studying our economy (which greatly fails to solve fundamental information problems) can help us to learn more about computers and brains (although I see it working the other way around).
igopogo 03:25 17 Dec 11
These comments are offbase. One can't "do" serious commentary without having any knowledge at all about the subject at issue, in this case neuroeconomics. One can't "assess" neurobiology from first principles untouched by knowledge of the brain. For instance, the Keynesian risk/uncertainly distinction, so important in Keynes's Chapter 12 and his 1937 QJE article, is central to the Keynesian message about economic fluctuations. Unless you think that Keynes is not a reliable informant on Keynes, you might wish to accept this point. Second, the neuroeconomics literature does not produce any "result" that say Keynes was right or wrong in his economc arguments,. Nor does that literature, Schiller to the contrary (I think, but he's cagey) notwithstanding, tell us that "rationality" is dead. We knew that such primitive rationality arguments went nowhere at least since Allais, Ellsberg, et al. a half century ago.
What the new neuroeconomc studies on this matter say, for instance on the Keynes claim, is that "yes, different brain processes are involved in experiments in which subjects are 1) making choice decisions in situations of risk versus 2) making choice decisions in in situations of ambiguity (uncertainty)." In short, Keynes was at root correct -- his insight was to see the implications of this distinction for economic theory --to argue that these two kinds of choices are truly different, and each leads to a different kind of decision process at the human behavior level. It is not however possible to draw any conclusion about which economic vision is "correct". Keynes' distinction is real, not illusory as some economists have argued. Whether the distinction confirmed by neuroeconomics experiments maps onto economic theory, or any resulting applied policy, is a matter untouched by neuroeconomics.
Fred 04:47 17 Dec 11
The below link is a to an 18 question survey recreating Allais’ paradox and Prospect Theory with updated amounts and certainty percentages. It will only take a couple minutes to complete and the additional qualifications will assist in explaining the violations to the violations of expected utility theory.
https://www.surveymonkey.com/s/arm2011e
fred_reade 08:09 02 Jan 12
No mention of Daniel Kahneman in this piece? It seems like an oversight to me. How many research psychologists have won the Nobel Prize in economics lately? Perhaps the next step in neuroeconomics is to research the cognitive processes of the "corporate person" to compare and contrast it to the cognitive processes of an actual human being. Where is the novelist for that project? Richard Powers where are you?
TMMCahal 03:19 21 Nov 11
'He concluded that much of our business cycle is driven by fluctuations in “animal spirits,” something in the mind – and not understood by economists.'
Dr. Shiller,
Keynes did not think this. He believed business cycle fluctuations - particularly severe ones - were caused by excessively high interest rates.