Mind Over Money
Can markets be rational when humans aren't? Airing April 26, 2010 at 9 pm on PBS Aired April 26, 2010 on PBS
In the aftermath of the worst financial crisis since the Great Depression, NOVA presents "Mind Over Money"—an entertaining and penetrating exploration of why mainstream economists failed to predict the crash of 2008 and why we so often make irrational financial decisions. The program reveals how our emotions interfere with our decision-making and explores controversial new arguments about the world of finance. In the face of the recent crash, can a new science that aims to incorporate human psychology into finance—behavioral economics—help us make better financial decisions?
Mind Over Money
PBS Airdate: April 27, 2010
NARRATOR: Does raw human emotion dictate your financial decisions, or are we rational calculators of our own self-interest? It's a bitter scientific debate that has real-world consequences.
The crash of 2008 nearly collapses the global economy. A set of amazing experiments reveals it was no surprise.
Experiments show our behavior is bizarre when it comes to money, but not everyone agrees. What happens when two powerful forces collide? Mind Over Money, right now on NOVA.
ZACH BURNS (University of Chicago): Okay, who's ready?
NARRATOR: It's an unusual experiment that challenges all our ideas about money:...
ZACH BURNS: Who wants to bid?
NARRATOR: ...an auction of a twenty dollar bill.
BIDDER ONE: One dollar.
ZACH BURNS: Do I hear two dollars? Who's got...?
BIDDER TWO: Two dollars.
ZACH BURNS: Do I hear three? Three in the back. How about four?
You want five?
BIDDER THREE: Five.
ZACH BURNS: Six?
BIDDER FOUR: Six.
ZACH BURNS: Seven?
BIDDER FIVE: Seven.
NARRATOR: The rules are simple. The highest bidder will get the 20-dollar bill.
BIDDER SIX: Ten.
ZACH BURNS: Eleven? Eleven. Twelve. Do I hear 13?
BIDDER FIVE: Thirteen.
NARRATOR: But there's a catch.
ZACH BURNS: Thirteen. Oh, that's great.
NARRATOR: The second highest bidder receives nothing but pays the amount of the losing bid.
ZACH BURNS: Do I hear 20?
BIDDER SEVEN: Twenty.
ZACH BURNS: Twenty dollars.
NARRATOR: Amazingly, two participants bid way above the face value.
BIDDER EIGHT: Twenty-six.
ZACH BURNS: Twenty-six!
BIDDER SEVEN: Twenty-seven.
ZACH BURNS: Twenty-seven going once...
BIDDER EIGHT: Twenty-eight.
ZACH BURNS: Twenty-eight! How about 29?
Twenty-eight going once, 28 going twice...
NARRATOR: So why would anyone pay more then 20 dollars for a 20-dollar bill?
ZACH BURNS: Twenty dollars sold for $28 to this gentleman.
NARRATOR: A group of scientists, called behavioral economists, think they have the answer.
JENNIFER LERNER (Harvard University): It just popped, and now he starts again.
NARRATOR: They believe that when it comes to making decisions about money, the human mind often behaves irrationally.
JENNIFER LERNER: We see a variety of ways in which people depart from rationality. People are not using the information they say they should be using, and instead they're using other information that they told us one would be crazy to use.
I'm going to measure your skin temperature.
NARRATOR: The notion that people can behave irrationally when it comes to money may not seem like a radical idea, but it challenges the dominant economic philosophy that has shaped policy in business and government for the last five decades.
The intellectual heart of this philosophy is here at the University of Chicago. This campus has given rise to more Nobel Prize winners in economics than any other institution in the world. Nearly all of them share a common assumption that when it comes to money people are highly rational.
One of the great champions of this view is Gary Becker.
GARY BECKER (University of Chicago): The most powerful theory we have, and I think it's the most powerful theory in the social sciences, is economics as a theory of rational behavior at an individual level, and that's the theory we rely on.
JOHN COCHRANE (University of Chicago): So what is economics? Economics is a way of thinking about things.
NARRATOR: University of Chicago professor John Cochrane is another leading proponent of this rational model of economics.
JOHN COCHRANE: And how do we do it? We start by thinking about people and by thinking about how people behave...people's behavior. What do they want? How do they go about getting it?
NARRATOR: It's a model first revealed 200 years ago by the father of economics, Adam Smith, in his book Wealth of Nations.
JOHN COCHRANE: He started economics in a way that Newton and Galileo started physics. He defined our field, in some sense, and came across some of the basic insights that people working in their self-interest could coordinate in markets and produce wonderful outcomes.
NARRATOR: So what did Adam Smith mean by rational and self-interested behavior? Take an average person in today's world. He's constantly calculating ways to increase his wealth.
GARY BECKER: Adam Smith basically said people are rational, selfish even, so...a very narrow form of rationality.
NARRATOR: Before he makes a purchase, he works out exactly what things are worth to him. Be it a cab ride or buying stocks, his goal is never to pay a cent more than he must. And, while he has emotions, they never sway him from his own financial self-interest. For Smith, individuals behaving rationally are an invisible hand that keeps the whole economy stable.
GARY BECKER: He put it all together and he ended up with results that are very modern. I mean, you know, economists over the years have modified it a bit, but Adam Smith really had the basic insight.
NARRATOR: Two centuries later, economics has evolved into a rigorous discipline.
JOHN COCHRANE: Having understood behavior, having thought about the markets where people interact with each other, we understand the predictions of that model for the facts.
NARRATOR: And Smith's insights into how rational people make financial decisions are now expressed in precise mathematical equations.
JUSTIN FOX (Harvard Business Review): Starting after World War II, you had to say it mathematically if you were going to be taken seriously. Economics, from the very beginning, had been the study of rational greedy people making decisions to try to enrich themselves. And it turns out you can come up with some pretty elegant ways of expressing that mathematically.
NARRATOR: Today, these mathematical models are the main tools used by economists to shape policies that affect us all, from the interest rates set by the government and the level of taxes, to how much we can borrow from banks.
Behavioral critics of these models believe they take Adam Smith's insights to an extreme.
ROBERT SHILLER (Yale University): They represent people as doing immense calculations with immense databases.
NARRATOR: The main model of consumer behavior assumes that we never buy anything until we've calculated the impact on, for example, our retirement fund, and we're so good at math we use interest rates to compute our pleasure, over time, after buying something.
ROBERT SHILLER: What are you talking about? What interest rate do I have in my head? That's the kind of thing that the models require that everyone is consistent about.
NARRATOR: Rational economists concede that people don't actually do these calculations, but they have a well-known defense: "as if."
EUGENE FAMA (University of Chicago): The way economics textbooks are written, they don't say people behave this way, they say people behave "as if" they were doing this.
JOHN COCHRANE: We're not assuming that the people in the real world actually make those calculations; we're simply saying that they behave as if they do.
NARRATOR: Behavioral economists like Richard Thaler are unconvinced.
RICHARD THALER (University of Chicago Booth School of Business): Defending economic theory, economists made a point about expert billiards players: they might not know anything about physics or trigonometry, but they play as if they do. Now, that's ridiculous.
Let's take an easy shot, like this. I might be able to make this shot, and an expert would make it. I can make it too, but let's think about...let's suppose I want to put this ball in this pocket. Now, I know the trigonometry; I've got to get the angles right and so forth. An expert would have no problem with it, but for me, this is a pretty hard shot.
Most of the time, we're not expert billiards players. When people face hard problems, they make mistakes.
NARRATOR: At the center of all the rational models lies an unflinching belief in free markets. The idea is to keep regulation and government interference to a minimum, in both the every day consumer market and in the giant money markets of Wall Street.
Rational economists believe that the increase in wealth, worldwide, over the last 30 years, is a triumph for free markets.
GARY BECKER: It lifted maybe a billion people out of real poverty, and I mean real poverty, but they had one dollar a day or two dollars a day. That's real poverty. And it lifted those people above those limits.
ARCHIVE AUDIO NEWS CLIP: What in the world is happening on Wall Street?
NARRATOR: Then comes the crash of 2008.
ARCHIVE AUDIO NEWS CLIP: Investment traders say they've never seen anything like it.
NARRATOR: The stock market drops over 40 percent...
ARCHIVE AUDIO NEWS CLIP: The Dow traders are standing there, watching in amazement, and I don't blame them.
ARCHIVE AUDIO NEWS CLIP: Traders here, working the phones, say a lot of their customers are freaked out, waiting to see how low the Dow will go.
NARRATOR: ...and apparently irrational financial behavior becomes the order of the day.
ARCHIVE AUDIO NEWS CLIP: Let's talk about the speed with which we're watching this market deteriorate.
NARRATOR: Fourteen-trillion dollars of wealth invested by Americans is destroyed.
ARCHIVE AUDIO NEWS CLIP: This has truly been a manic Monday on Wall Street.
NARRATOR: Fear grips the markets.
ARCHIVE AUDIO NEWS CLIP: The stock market suffered one of its worst days in years.
NARRATOR: And financial experts are forced to imagine the once impossible:...
ARCHIVE AUDIO NEWS CLIP: We haven't seen anything like this since the Great Depression.
NARRATOR: ...the global economy coming to a halt.
LEO MELAMED (Chicago Mercantile Exchange): I shudder to think if all of that stopped. The consequences are beyond imagination: there would be hunger; there would be war; there would be strife; there would be total unemployment.
ARCHIVE AUDIO NEWS CLIP: We're having an electronic run on the banks.
LEO MELAMED: It would put the world back a hundred years, maybe more.
NARRATOR: The chaos seems to undermine decades of economic thinking.
GARY BECKER: Economists as a whole didn't see it coming. So that's a black mark on economics, and it's not a very good mark for markets.
ARCHIVE AUDIO NEWS CLIP: This market took five years to go higher; it's now down 40 percent; this was in one week.
NARRATOR: With the crash, the rift in economics widens between the rationalists and the behavioralists.
ARCHIVE AUDIO NEWS CLIP: We are talking about financial Armageddon.
JENNIFER LERNER: The crash really matters, because much of the behavior that led up to the crash is unexplained by the discipline of economics.
JOHN COCHRANE: I'm sorry, that's such an empty argument. That's just an insult, a pointless insult.
EUGENE FAMA: I don't see this as a failure of economics, but we need a whipping boy, and economists have always, kind of, been whipping boys, so they're used to it. It's fine.
NARRATOR: So which side is right? Are we rational about money, or do our emotions and psychology play a much bigger role than previously realized?
ZACH BURNS: Okay, everyone, we're going to start off with a game.
NARRATOR: Take the auction of the 20-dollar bill that sold for 28.
ZACH BURNS: Do I hear one dollar?
BIDDER ONE: One, one dollar.
ZACH BURNS: How about two?
BIDDER TWO: Two, two dollars.
NARRATOR: In the rational model, a person should never pay 28 dollars for a 20-dollar bill.
ZACH BURNS: Six? How about six?
BIDDER SIX: Six.
NARRATOR: Paying more than something is worth cannot be in anyone's best financial interest.
The auction is a key experiment of behavioral economics.
RICHARD THALER: It's designed to be a trap, and it's a trap that, if you don't think more than a couple steps ahead, you fall into.
ZACH BURNS: Eleven? Eleven. Twelve. Do I hear 13?
NARRATOR: It's the emotional desire to win that drives bids up.
ZACH BURNS: Fourteen? Fourteen! Fifteen.
Do I hear 20? Twenty dollars.
NARRATOR: And fear of being the loser drives them even higher.
BIDDER EIGHT: 23.
BIDDER SEVEN: 24.
BIDDER EIGHT: 25.
RICHARD THALER: And now it's a game of chicken.
ZACH BURNS: Twenty-six!
BIDDER EIGHT: Twenty-seven.
ZACH BURNS: Twenty-seven going once...
BIDDER SEVEN: Twenty-eight.
ZACH BURNS: Twenty-eight!
Twenty dollars sold for $28 to this gentleman.
BIDDER SEVEN: What a deal.
ZACH BURNS: And you owe me $27, as well.
RICHARD THALER: Nobody will want to play that game twice.
NARRATOR: The auction may seem far removed from everyday life, but do people outside of the classroom behave just as irrationally?
We asked shoppers in a Chicago mall if they would prefer $100 in a year's time or $102 in a year and a day.
MALL SHOPPER ONE: I'll take the $102 in a year and one day.
MALL SHOPPER TWO: A hundred and two dollars.
MALL SHOPPER THREE: Year plus a day.
MALL SHOPPER FOUR: I mean, I can wait that extra day for it, the $102.
MALL SHOPPER FIVE: It really wouldn't make any difference.
MALL SHOPPER SIX: I would do the 102 a year and a day from today.
NARRATOR: They all made the rational decision...
MALL SHOPPER SIX: What's one day after a whole year of waiting?
NARRATOR: ...and chose the bigger amount. Then they were asked if they would prefer $100 today or $102 tomorrow. The larger amount is still the rational choice. So what did they say?
MALL SHOPPER ONE: I'll take $100 right now.
MALL SHOPPER SIX: I would take $100 today.
MALL SHOPPER FOUR: I would prefer the $100 today.
MALL SHOPPER THREE: Today.
MALL SHOPPER FIVE: I'm taking the $100 today.
NARRATOR: The desire for a quick reward....
MALL SHOPPER SIX: One hundred dollars today.
NARRATOR: ...trumps their rational self-interest.
RICHARD THALER: There's something called "present bias," that if we have the option of something right now, it's very tempting to go for it.
NARRATOR: According to behavioral economists, this bias may explain why we save less than we should.
And there are other psychological forces that impact our decisions.
AUCTIONEER: ...a bottle of wine.
NARRATOR: In this experiment, students are asked to bid for a bottle of wine.
NARRATOR: Rational economics suggests they will carefully calculate what it's worth to them, but before the bidding begins, they're asked to write the last two digits of their Social Security number on their bid sheet.
Astonishingly, the people who bid the highest for the wine were those who had the highest Social Security numbers. Unwittingly, they have been influenced by a completely irrelevant number.
RICHARD THALER: It is a great illustration of anchoring. People are anchored on some number they were given, even when they constructed it at random, like the last two digits of their social security number. It's an almost irresistible force.
NARRATOR: Do experiments like these expose flaws in the assumptions underlying rational economics?
GARY BECKER: They're dealing with people in the lab. Economists are dealing with people in the real world, and there's a difference between the lab and the real world.
JOHN COCHRANE: These experiments are very interesting, and I find them interesting, too. The next question is, to what extent does what we find in the lab translate into how people...understanding how people behave in the real world...and then make that transition to, "Does this explain market-wide phenomenon?"
NARRATOR: For economists like Cochrane, it doesn't matter if individuals sometimes go against their financial self-interest, as long as most of us act rationally about money most of the time.
Nowhere is that idea more important than here: the New York Stock Exchange, where traders buy and sell corporate stocks. Their decisions move prices up and down, creating wealth for some investors and financial loss for others.
Richard Rosenblatt's been trading here for 30 years.
RICHARD ROSENBLATT (New York Stock Exchange): When I started, the technology was electric lights and telephones. And yet it's still the same job: trying to anticipate where the stock is going to move over the next few seconds or minutes and judge your trading decisions accordingly. And if I'm right, and I buy a stock in anticipation of other people deciding that this stock is underpriced, then I'll realize a profit.
NARRATOR: Now, the stock exchange is one small cog in a vast global machine that is the financial markets. Technology means trading can take place anywhere.
KNIGHT CAPITAL GROUP TRADER ONE: Trading on two bucks on earnings; we've got 15. Buy.
NARRATOR: At Knight Trading, one of the biggest private dealing floors in the world, traders buy and sell everything from stocks and currencies to commodities like oil and gold.
KNIGHT CAPITAL GROUP TRADER ONE: You know what? I have stuff in the opening. I won't pay over that.
KNIGHT CAPITAL GROUP TRADER TWO: Eight dollar, two on the upside on eight. Sell!
NARRATOR: And just as Adam Smith suggested, traders here compete fiercely to make as much money as possible for their clients and themselves.
JOE MAZZELLA (Knight Capital Group): You want to win. And it's the competitive nature of all of us that drives us to push harder and harder each day. You know, as the room gets busier and busier, and the noise starts to elevate, if I'm sitting here, and I'm not that active, and I see somebody next to me who's busier than I am, it gets me going.
KNIGHT CAPITAL GROUP TRADER THREE: Hey, Tommy! The 38,000 guy added 50, so...
KNIGHT CAPITAL GROUP TRADER FOUR: T.X.M. for a buyer. Twenty-three-ninety for 100.
NARRATOR: Why does it matter what happens in places like this?
Most of us use financial products like mortgages or mutual funds.
The firms that sell us these products take our money and invest it to make more money in the financial markets. If traders make profits for these financial firms they can then offer us cheaper mortgages and better mutual fund returns. The result: a matrix of money that connects us all.
It's built on an economic model that says most of the time most of us, and most of the traders, behave rationally. But what if this model of human behavior isn't right?
ARCHIVE AUDIO NEWS CLIP: Stocks shot higher, giving the Dow its best day in almost two years.
NARRATOR: In 2005, rational economics, it seems, has delivered. Times are good and have been for years.
ARCHIVE AUDIO NEWS CLIP: There's a hot real estate market in many parts of the country right now.
NARRATOR: Many think the long boom will continue.
ARCHIVE AUDIO NEWS CLIP: Earnings jumped almost eight-fold.
ARCHIVE AUDIO PRESIDENT GEORGE W BUSH NEWS CLIP: Our economic horizon is as bright as it's been in a long time.
ARCHIVE AUDIO NEWS CLIP: For those in the housing business, these are gold-rush days.
NARRATOR: Economist Robert Shiller is unconvinced.
ROBERT SHILLER: It did seem to me that there was complacency and an overriding feeling of normalcy that this can't be wrong.
NARRATOR: He thinks the boom is a mirage.
ARCHIVE VIDEO NEWS CLIP: While the real estate market has grown to new heights and new prices never seen before...
NARRATOR: He's worried about one thing in particular: housing. Housing prices have gone up six percent a year for decades. In 2005, in some places they're rising at 25 percent.
ROBERT SHILLER: This was very anomalous performance. The idea that home prices always go up led people to think that they had all found the investment of all investments.
ARCHIVE AUDIO NEWS CLIP: Thousands came to a two-day expo hoping to learn how how they could turn investment in real estate into personal riches.
NARRATOR: Shiller believes America is in the grip of an irrational mania.
ROBERT SHILLER: I predicted it was likely to correct down and might cause a huge financial crash and a worldwide recession.
NARRATOR: On a book tour, that summer, he warns of the dangers.
ARCHIVE AUDIO NEWS CLIP: Economist Robert Shiller is out with a new book titled Irrational Exuberance.
ROBERT SHILLER (In 2005 News Interview): It's kind of a frame of mind we get into, when prices keep going up and we see a lot of excitement. That's irrational exuberance.
NARRATOR: Rational economists dismiss his warnings.
JOHN COCHRANE: What does "irrational exuberance" mean? It's a lovely buzzword for a view that prices are higher than Bob Schiller thinks they ought to be.
EUGENE FAMA: Bob, who's a friend of mine, has been consistently pessimistic about prices.
NARRATOR: The debate about whether rising house prices are the result of a mania or rational calculation intensifies.
GARY BECKER: The individual household was not being irrational. They were getting low down payments, low interest rates, so it was a rational decision to make, particularly when they expected prices to continue to rise over time.
NARRATOR: Financial institutions share the conviction that house prices will continue to rise.
They offer mortgage deals never seen before. And the country's top financial officials are optimistic.
ALAN GREENSPAN (Former Chair, Federal Reserve System/C-Span Archive Video): The U.S. economy has weathered such episodes before, without experiencing significant declines in the national average level of home prices.
BEN BERNANKE (Chair, Federal Reserve System/C-Span Archive Video): House prices have risen by nearly 25 percent over the past two years. At a national level, these price increases largely reflect strong economic fundamentals.
NARRATOR: This confidence isn't just a shared hunch, it's based on the widely accepted models of rational economics.
JUSTIN FOX: Basically, you build the models assuming people were like these calculators who would look at the range of possible outcomes and the risks and balance it all out.
NARRATOR: In 2005, the economic models assume consumers will make careful calculations about their mortgages.
RICHARD THALER: Economists assume we shouldn't worry about people taking out 95-percent mortgages or 100-percent mortgages or "trust me" mortgages, because they'll only take out those mortgages if they have made all the relevant calculations.
NARRATOR: Instead, as housing prices soar, many consumers take out mortgages they cannot afford, and assume debt based on the rising value of their homes.
So why might so many people be willing to take on so much risk? At Stanford University, researchers stumble on a possible answer. Their research, at first, has nothing to with money. It isn't even being conducted by economists. Psychologists are using powerful brain scanners to explore the mysteries of the human mind, especially emotion.
BRIAN KNUTSON (Stanford University): I started looking into the brain because I was interested in emotion, and I was convinced that there must be something in there that could give us a handle on emotion.
NARRATOR: Psychologist Brian Knutson wants to know how emotions affect one of the oldest parts of our brain, that evolved so long ago we share it with many creatures, even lizards.
BRIAN KNUTSON: In general, the lower the area of the brain, the farther back it goes in evolution, right? And it generalizes across species, so we humans still have these sub-cortical areas, deep in the brain, that are ancient.
NARRATOR: This part of the brain is called the "nucleus accumbens," and it gets triggered by the most primal human needs.
BRIAN KNUTSON: From the standpoint of survival, it makes a lot of sense that natural rewards, like food and sex and so forth, would activate this circuit that makes you go out and get those rewards.
NARRATOR: This part of the brain plays a crucial role in drug addiction. Out of curiosity, Knutson tries to find things that excite it as much as the prospect of sex and drugs. So he asks people to imagine they are about to receive some money.
BRIAN KNUTSON: Once we started to use money, we found very reliable activation in these emotional circuits. This means it's not just sex, it's not just drugs, it's not just food that activates these circuits, money also activates these circuits, and it does so very powerfully.
NARRATOR: Could the fact that an ancient part of our brain gets excited by money explain some of the frenzied behavior by financial traders and consumers during the housing boom?
Rising house prices are an example of a phenomenon called a "speculative bubble," when prices of a financial asset suddenly take off and keep rising.
Robert Shiller believes it's emotional excitement that drives them.
ROBERT SHILLER: What's going on is that, as the bubble grows, more and more people are coming in. And they're coming in out of envy for the other people who are shamelessly boasting, "I made more money than you did all last year, working." And for a while, you think it can't be right. But then you think, "Maybe I was wrong, maybe I should get into this." And it's really driven by human emotion.
NARRATOR: This link with emotions is what makes many rationalist economists reject the idea of bubbles.
EUGENE FAMA: I used to think I knew what the word bubble meant, but I don't think I know what it means anymore. I cancelled my subscription to The Economist because the word "bubble" appears three times in every page there now, and I think it's just totally gratuitous. It's mindless.
NARRATOR: Bubbles sound innocuous, but financial journalist Justin Fox has studied their history and discovered what happens when they burst.
The first financial bubble involved something highly unlikely.
JUSTIN FOX: In the 1630s, in the Netherlands, people were buying and selling Tulip bulbs...complete, mass insanity in Holland, for a couple of years there, where hundreds of people, artisans, would leave their workshops and set up business as "florists," they called themselves, although, for the most part, what they really were were tulip bulb traders. And it was a real financial market.
ROBERT SHILLER: The price of tulips in Holland rose to such a level that the value of one tulip bulb would sometimes be that of an entire house.
NARRATOR: Over a three-year period, the price of tulip bulbs rose and rose, and then began to soar. By some accounts, almost half of all the money in the Dutch economy was caught up in trades involving tulips.
JUSTIN FOX: To a lot of historians, this is really the first example of a financial bubble, even though it was, basically, tulips.
ROBERT SHILLER: People were buying them, not primarily because they liked tulips, but they were buying them because they thought that the price was going up and they could resell them to someone else at a higher price.
NARRATOR: On February 5, 1637, the most expensive bulb in Holland failed to sell, and tulip investors panicked.
ROBERT SHILLER: Then it burst, because prices start falling. And then they're falling more, and then you start thinking, "You know, I remember I doubted that tulips could possibly be worth so much. Maybe I better get out fast." And then everyone starts dumping, and then it just drops.
NARRATOR: As the prices plunged, leading citizens found themselves bankrupt. Some historians estimate it took a generation for the Dutch economy to recover.
There have been many bubbles and crashes since, but the most famous happened closer to home.
The year 1929 began with optimism. Stock prices had been rising for eight years, and in '29 they were soaring.
JUSTIN FOX: The 1920s was a great decade economically. The economy was booming, industry was booming, and toward the latter part of the decade, financial markets just sort of went from reflecting that boom to, kind of, creating it. It was just boom times all over. By the late 1920s, there was just this feeling of a new era.
NARRATOR: Observers described feverish emotions, as thousands of investors paid ever-higher prices for stocks.
ROBERT SHILLER: In the so-called "roaring '20s" the stock market went through an enormous bubble; people thought it would never end.
NARRATOR: But then, on October 29th, prices suddenly dropped, and the mood turned to one of panic and fear. Over 9,000 American banks failed, wiping out the life savings of millions.
ROBERT SHILLER: It led to a depression that lasted over 10 years.
GARY BECKER: We had 25 percent unemployment for most of the decade of the 1930s.
ROBERT SHILLER: It was an event that was driven by a real change in people's psychology that lead them to be very optimistic and positive in the 20s and then negative in the 30s.
NARRATOR: This view that emotions can drive an economy up or down became the conventional wisdom of the 1930s, through the work of the renowned British economist John Maynard Keynes.
JOHN MAYNARD KEYNES (Economist/Video Clip): There's a new danger of a serious rise of the cost of living.
JUSTIN FOX: Keynes believed that financial markets arrived in a pretty crazy fashion. His classic quote is that the market could stay irrational longer than you can stay solvent.
NARRATOR: Keynes said emotions could cause prices to soar and then collapse, and to protect the economy from these dangerous bubbles, the markets had to be firmly regulated by government.
Keynes, though, could never explain exactly what the mechanism was.
ROBERT SHILLER: Keynes never got past the fuzzy stage, and it didn't lead him to a precise mathematical model. And that's why, ultimately, Keynes was rejected by the profession.
NARRATOR: Now, after the crash of 2008, behavioral economists are struggling to do what Keynes could not: show precisely how human emotions affect prices. Their ideas are so influential that behavioral experiments are now conducted even at the University of Chicago, the citadel of rational economics.
One explores a mysterious psychological bias.
ZACH BURNS: We are interested in how much you would pay for this mug or one identical to it.
NARRATOR: These students have been told to work out the price of a common consumer item.
ZACH BURNS: ...a travel mug, in beautiful maroon.
NARRATOR: They're asked, first, what they would be prepared to pay to buy the mug.
ZACH BURNS: Let's think about it for a moment and then write down the maximum amount you'd be willing to pay for this mug or one identical to it.
NARRATOR: They offer an average of six dollars.
ZACH BURNS: So we now have six of these mugs. We're just going to raffle them off by selecting a few people at random.
NARRATOR: And then they're given the same mug for nothing. An hour later, they're asked how much they'd be willing to sell it for. In rational economics, the price should be exactly the same. After all, the value hasn't changed.
But the average price they want for the mug now is nine dollars.
ZACH BURNS: ...wanted to sell the mug back, once you had it, you gave a higher price.
RESEARCH SUBJECT ONE (University of Chicago):It just made it seem a little bit more special, because it was going to be something useful to me.
ZACH BURNS: Anybody else?
RESEARCH SUBJECT TWO (University of Chicago): Well, I got this mug by complete luck, and so it's important to me, and so I have to charge this much for it.
NARRATOR: The emotional pleasure of owning something for just an hour pushed the price up by 50 percent. It's an unexpected outcome, suggesting we are unaware of the emotions that drive this behavior.
At Harvard, researchers are exploring the financial impact of these subtle influences. The team is led by Jennifer Lerner.
JENNIFER LERNER: I'm a social psychologist, not a clinical psychologist. I don't do counseling, therapy, et cetera. I do experiments in a laboratory. I come with the assumption that much of what's going on in terms of influencing a decision is outside of conscious awareness.
NARRATOR: Lerner explores all sorts of emotions. Today it's sadness and how it impacts on financial decisions.
JENNIFER LERNER: We're going to start by placing these two sensors. They measure skin conductance, or sweating response.
NARRATOR: The experiment is designed to induce emotions at such a low level the subjects aren't aware of them.
JENNIFER LERNER: ...fairly snug. It's going to measure your skin temperature.
NARRATOR: So the researchers use sensors to track the physiological effects of the emotion...
JENNIFER LERNER: So now we're going to get ready to collect the first saliva sample.
NARRATOR: ...from heart and breathing rate, to the hormones in saliva.
JENNIFER LERNER: These are physiological signals from the subjects. When we have them first come in, they sit and have a period of quiet rest, relaxing to music, that sort of thing, so we can see what they're like at baseline. And then we use that to compare what happens when they might be in the midst of a stressful financial decision.
NARRATOR: Among other activities, the subjects watch a scene from a sad movie. Unbeknownst to them, this triggers low-level sadness. Their sensors reveal the emotional change.
JENNIFER LERNER: The decision-makers in our studies are completely unaware that the sadness is impacting them. And when we ask them, did the film you saw change your responses in any way, they say no.
NARRATOR: It's time for the financial test. The subjects are directed to make a series of financial choices. Then, they are asked how much they would pay for a consumer product, in this case, a water bottle.
Lerner compares their choices to those of a group not shown the sad video.
JENNIFER LERNER: Here is an example of a subject in the neutral condition, and this subject is telling us that they would like to buy it at two dollars and fifty cents. And that contrasts with, here, we have data from a subject who's in the sad condition, and this subject is willing to pay $10 to obtain the water bottle. And that is very representative of what we see. You get this increased valuation when you're sad.
NARRATOR: If sadness can lead people to pay four times more for a water bottle, what happens when the stakes are higher?
JENNIFER LERNER: The experiments have been done with high stakes money—a thousand dollars, et cetera—and what we find is that these results scale up, even when you use big money.
NARRATOR: If emotions influence prices on the individual level, what about markets and the larger economy?
According to rational economics, these are driven by individual self-interest, but for Robert Shiller, this ignores something obvious.
ROBERT SHILLER: Humans are empathetic animals, uniquely empathetic. We're not just communicating ideas, we're communicating emotions. That's what empathy means. It's different from sympathy. It's that I am feeling the same thing; I know what you're experiencing because it's in my body too, the same feeling that you have.
ARCHIVE AUDIO NEWS CLIP: There's a hot real estate market in many parts of the country right now.
NARRATOR: If Shiller is right, could empathy explain how the hyper-optimism of the housing market jumped, like a social contagion, to the financial markets?
ARCHIVE AUDIO NEWS CLIP: The real estate market has grown to new heights and new prices.
NARRATOR: Among professional traders, the idea that moods sweep through markets is taken for granted.
DAN MATHISSON (Credit Suisse): The market is an aggregation of what thousands of people think the future is going to be like. And if these people are optimistic about the future, the market goes up, and if people are pessimistic about the future, the market goes down. But at the end of the day, the question the market answers is, "Are people optimistic or are they pessimistic?" And that's a psychological question. Emotion still drives the markets.
ARCHIVE AUDIO NEWS CLIP: They're saying that the bubble will not burst, there's plenty of room left to run.
NARRATOR: For rationalists, emotions are not a satisfactory explanation for how markets work.
JOHN COCHRANE: The observation that people feel emotions means nothing. And if you're going to just say markets went up because there was a wave of emotion, you've got nothing. That doesn't tell us what circumstances are likely to make markets go up or down. That would not be a scientific theory.
NARRATOR: The rationalists' conviction is based on the mathematical model they use to understand the financial markets.
It's called the "efficient markets hypothesis," and it says that financial markets act, essentially, like a giant calculating machine, efficiently processing all relevant information faster than any individual could. So, if some traders are emotional, it doesn't matter.
EUGENE FAMA: Efficient markets can exist side by side with irrational behavior, as long as you have enough rational people to keep prices in line.
NARRATOR: In the efficient markets model, the financial markets themselves are rational, and prices, at any moment in time, cannot be wrong.
It was a model invented by Eugene Fama.
EUGENE FAMA: It's a pretty good model. And for almost every practical use you would put that model to, it works pretty well. It created a big fuss and the fuss persists to this day.
NARRATOR: The fuss persists because, for many behavioralists, the theory implies financial markets should be immune from criticism or control.
ROBERT SHILLER: The theory is that we have to look at markets as oracles. When the market moves up, we have to say, "What is the wisdom of the market telling us, today?"
RICHARD THALER: If markets are efficient, there's no real need for government, because the market itself will make sure that prices are always equal to the right price.
NARRATOR: Instead of regulation, rationalists believe the markets will come up with their own mechanisms for managing risk. And so they have.
The first was invented here at the Chicago Mercantile Exchange, where traders handle vast sums of money, all the time.
HARRY PANKAU (Chicago Mercantile Exchange Trader): I'm an independent trader, and I trade my own money, 50 contracts to 100 contracts at a time. That's basically a 50-million to 100-million-dollars contract size.
NARRATOR: Traders here make their money by effectively offering to insure people against risk, including agricultural producers of pork bellies and oranges.
LEO MELAMED: Long before this orange became an orange, the farmer had to grow it. He doesn't know what will be the price of that orange when it comes to the market, finally, 10 months later. Will he make a profit?
NARRATOR: As protection, farmers take out contracts to insure themselves against the price of oranges dropping.
LEO MELAMED: Nowhere in the market are you going to see an orange pass from one trader to the next. And yet, oranges were transacted in an invisible market. That is a risk transfer mechanism.
NARRATOR: When he was chairman of the Exchange, Leo Melamed took that idea with oranges and applied it to financial assets. In a contract, that became known as a derivative.
LEO MELAMED: It was a revolutionary idea. The board of directors looked at me as if I was half crazy. "What do you mean? At the Chicago Mercantile Exchange? The pork belly exchange? You've got to be crazy Melamed, you're going to take this exchange and blow it up."
NARRATOR: If you're worried that a financial asset like a currency or a stock might suddenly move down, you can now buy a derivative that pays you if that happens.
LEO MELAMED: Everyone in the world uses one or another form of financial derivatives to insure the risks that they have.
NARRATOR: Derivatives are so useful, they move beyond the mercantile exchange, and, with less oversight, take on complex new forms. There are even some created to insure the risks of issuing millions of home mortgages.
But as all these different risks grow someone has to measure them.
At the modern temples of finance, the atmosphere is less Chicago Mercantile and more like academia. No wonder; the average trader here is likely to have a graduate degree in math.
DAN MATHISSON: The culture of trading has changed. When I started in this business, which wasn't that long ago, in 1992, there was a lot of screaming and yelling on the trading floors, people were throwing phones. Today, you go out on the trading floor and it's relatively quiet. There's a lot of tapping of computer keys, and it's a different type of person involved in trading.
NARRATOR: These traders are called "quants," because they use equations and statistics to quantify their risks mathematically. Only then do they program their computers to make trades.
The financial markets are now dominated by the highly mathematical approach of the quants, one that's been designed to ensure risks are assessed rationally and scientifically.
DAN MATHISSON: There's still aspects of trading that are an art and not a science. What's changed is that there are now a lot of aspects that are treated as a science, and that's new over the last 20 years. A quant will troll through tons and tons of data, looking for patterns, and they're crunching numbers all day trying to improve performance.
NARRATOR: These two key innovations: derivatives to manage risk and mathematics to measure it, convince many that markets are efficient, making bubbles and crashes a thing of the past.
JEREMY GRANTHAM (GMO, LLC): If you believe that, you can believe that pigs will fly. When I first heard economists coming out with that idea, I assumed that they were very badly informed, off in their ivory towers.
NARRATOR: Jeremy Grantham is a highly successful investor. For the last 40 years he's made his money by spotting price bubbles and betting against them.
JEREMY GRANTHAM: We've found 27 bubbles.
NARRATOR: Grantham believes bubbles are inevitable and have a predictable rhythm.
JEREMY GRANTHAM: It's euphoria causing the price to go up and realism causing it to fall back, and then, eventually, unrealistic panic, as it begins to feed on itself, and the lemmings head in the opposite direction.
NARRATOR: At Chapman University, in California, this cycle is studied by Vernon Smith.
VERNON SMITH (Chapman University School of Law/2002 Nobel Prize Winner in Economics): A lot of economists do not like bubbles because they are so hard to understand.
NARRATOR: In this experiment, Smith wants to see what happens when students compete to earn money on a simulated trading floor.
RESEARCHER ONE (Chapman University): You'll be participating in a trading experiment.
RESEARCHER TWO (Chapman University): It's not a classroom setting. It's a setting in which your job is to make as much money as you possibly can.
RESEARCHER ONE: You will be paid based on the dividends that you have earned...
NARRATOR: If they play the game well, they could earn hundreds of dollars.
VERNON SMITH: This is real money, serious money.
NARRATOR: Each of them has been given an imaginary financial asset to trade.
RESEARCHER ONE: You will be trading an asset.
NARRATOR: And right from the start, they're told to be careful because the asset will decline in value over time. By the end of the game, it will be worth nothing.
RESEARCHER ONE: The asset will live exactly 15 periods of trading.
VERNON SMITH: And the question is whether this will determine the prices at which they exchange or whether the prices at which they trade deviate from that.
RESEARCHER ONE: Okay, the experiment has begun.
NARRATOR: On a screen, they see the prices the other traders are offering to sell or buy at. And they also see the value of the asset as it relentlessly declines, shown here as a dashed black line, heading downwards.
As prices rise, they reach the actual value of the asset, and something strange happens: everyone begins to take risks.
RESEARCHER TWO: So you notice the price as been racing up.
NARRATOR: In the hope of making profits, they now trade high above the real value.
RESEARCHER TWO: There's quite a frenzy, way above fundamental value.
NARRATOR: In the flurry of buying, the students are now ignoring the fact that the asset will soon be worthless.
RESEARCHER TWO: We're in period 10, and at the end of period 15, these assets are worth nothing.
NARRATOR: As the end approaches, the price remains way above the real value. The graph has taken on a classic bubble shape.
And when the players try to get out, no one wants to buy. Instead of earning hundreds of dollars, the students watch the graph collapse, leaving them with next to nothing.
This experiment suggests bubbles may be part of the fabric of financial markets.
VERNON SMITH: These experiments...we've done hundreds of them, now, and with all kinds of different subjects. I went to Chicago, and I recruited some over-the-counter-securities traders, put them in the experiment. They gave us a magnificent bubble.
NARRATOR: It's a bubble where prices go up and then, suddenly, plummet. How could such a simple pattern have brought us so close to economic catastrophe?
In 2005, as housing prices grow the mechanisms that rational economists count on to keep the markets safe become part of the problem. Major financial institutions issue billions of dollars worth of derivatives to protect mortgage lenders against home loan defaults.
MARK WHITEHOUSE (The Wall Street Journal): And every time you created one, you could make six percent of the total value you created. This was like a gold mine.
NARRATOR: These derivatives are traded, and their price soars, and suddenly they have become the 21st century equivalent of tulip bulbs. Within a few years, 60-trillion dollars is riding on them. All this is fine as long as the quants are calculating risk properly, but their mathematical model assumes the prices in markets are always correct.
MARK WHITEHOUSE: It was assuming that house prices would keep going up; it was assuming that very few people would default on some very risky loans; it was, essentially, assuming that there was no more economic cycle.
ARCHIVE AUDIO NEWS CLIP: Notice all those for sale signs out there on homes the owners just can't unload?
NARRATOR: When housing prices fall, the model breaks down. The price of derivatives plunges, leaving financial institutions with billions of dollars of debt.
MARK WHITEHOUSE: Banks couldn't sell these things at any price. So, effectively, their price was nothing.
ARCHIVE AUDIO NEWS CLIP: Shaky home mortgages are triggering fears of a financial meltdown on Wall Street.
JENNIFER LERNER: On the eve of the crash, there was a whole intellectual edifice, built on the assumptions of rational decision-making.
JUSTIN FOX: It's really hard to say that the market is rational and perfect and knows what it's doing, when it's clearly capable of freezing up and ceasing to function.
NARRATOR: As fear grips the market, financial firms pull back their money...
ARCHIVE AUDIO NEWS CLIP: There was blood on the floor at the end of trading on Wall...
NARRATOR: ...and refuse to lend to each other. And uncertainty leads to something that looks very much like panic.
EUGENE FAMA: You can give it the charged word "panic," if you'd like, but in my view it's just a change in tastes.
ARCHIVE AUDIO NEWS CLIP: Half a trillion dollars in mortgage investments have gone bad.
JOHN COCHRANE: Emotions is how human beings make rational decisions. You know, when that lion is coming, it's important that you feel some adrenaline and some fear, and that's how you make the rational decision to run like heck in the opposite direction.
ARCHIVE AUDIO NEWS CLIP: The Dow tumbled 240 points, while the NASDAQ...
GARY BECKER: Where do you take this? We have another 30 years like we have in the past, including this recession, it would be a great achievement for the world.
ARCHIVE AUDIO NEW CLIP: Those of us who have looked to the self-interest of lending institutions are in a state of shock, disbelief.
ROBERT SHILLER: We think we've got a good quantitative framework which takes care of all the risks, but it's missing something. It's a case where people believe the theory too much, and they were willing to make huge bets based on a theory that really wasn't right.
Mind Over Money
- Written, Produced, and Directed by
- Malcolm Clark
- Edited by
- Steve Audette
- David Adler
- Adam Finch
- Line Producer
- Vivienne Steele
- Associate Producer
- Samuel Goss
- Mark Molesworth
- Additional Camera
- Simon Fanthorpe
- Sound Recordist
- Greg Molesworth
- Lance Lewman
- Alex Harrison
- Assistant Editor
- Mandy Minichiello
- Online Editor and Colorist
- Michael H. Amundson
- Audio Mix
- John Jenkins
- Archive Research
- Rich Remsberg
- Joseph Johnson
- Production Assistant
- Juan Calatayud
- Archival Material
- ABC News Video Archive
Bridgeman Art Library
The Image Works
Special Collections, Wageningen UR Library
WPA Film Library
- Special Thanks
- General Growth Properties, Inc.
Museum of American Finance
New York Stock Exchange
- NOVA Series Graphics
- yU + co.
- NOVA Theme Music
- Walter Werzowa
- Additional NOVA Theme Music
- Ray Loring
- Closed Captioning
- The Caption Center
- Carole McFall
- Steve Sears
- Kate Becker
- Production Coordinator
- Linda Callahan
- Sarah Erlandson
- Talent Relations
- Scott Kardel, Esq.
- Legal Counsel
- Susan Rosen
- Production Assistant
- Ryan Murdock
- Post Production Assistant
- Darcy Forlenza
- Associate Producer, Post Production
- Patrick Carey
- Post Production Supervisor
- Regina O'Toole
- Post Production Editor
- Rebecca Nieto
- Post Production Manager
- Nathan Gunner
- Compliance Manager
- Linzy Emery
- Development Producer
- Pamela Rosenstein
- Supervising Producer
- Stephen Sweigart
- Business Manager
- Joseph P. Tracy
- Senior Producer and Project Director
- Lisa Mirowitz
- Coordinating Producer
- Laurie Cahalane
- Senior Science Editor
- Evan Hadingham
- Senior Series Producer
- Melanie Wallace
- Executive Producer
- Howard Swartz
- Managing Director
- Alan Ritsko
- Senior Executive Producer
- Paula S. Apsell
A NOVA Production by Twister Films Ltd for WGBH Boston
Images of NYSE Group, Inc., including the images of the NYSE Trading Floor and the Façade of the Exchange, each a federally registered trademark of NYSE Group, Inc., are used with permission of NYSE Group, Inc. and its affiliated companies. Neither NYSE Group, Inc. nor its affiliated companies sponsor, approve of or endorse the contents of this program. Neither NYSE Group, Inc. nor its affiliated companies recommend or make any representation as to possible benefits from any securities or investments. Investors should undertake their own due diligence regarding their securities and investment practices.
- Gary Becker
- University of Chicago home.uchicago.edu/~gbecker/
- John Cochrane
- University of Chicago faculty.chicagobooth.edu/john.cochrane/research/Papers/
- Eugene Fama
- University of Chicago www.chicagobooth.edu/faculty/bio.aspx?person_id=12824813568
- Justin Fox
- Harvard Business Review blogs.hbr.org/fox/
- Jeremy Grantham
- Chief Investment Strategist, GMO www.gmo.com/America/About/
- Brian Knutson
- Stanford University www-psych.stanford.edu/~knutson/
- Jennifer Lerner
- Harvard University www.hks.harvard.edu/about/faculty-staff-directory/jennifer-lerner
- Dan Mathisson
- Credit Suisse https://www.credit-suisse.com/who_we_are/en/
- Joe Mazzella
- Knight Capital Management www.knight.com/
- Leo Melamed
- Chicago Mercantile Exchange www.leomelamed.com/
- Richard Rosenblatt
- New York Stock Exchange rblt.com/aboutus.aspx
- Robert Shiller
- Yale University www.econ.yale.edu/~shiller/
- Vernon Smith
- Nobel Prize in Economics (2002) nobelprize.org/nobel_prizes/economics/laureates/2002/smith-autobio.html
- Richard Thaler
- Chicago Booth School of Business www.chicagobooth.edu/faculty/bio.aspx?person_id=12825835520
- Mark Whitehouse
- The Wall Street Journal www.anderson.ucla.edu/x30777.xml
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