Does. Raw human emotion dictate. Your financial, decisions I like, to shop I love shopping, so much or are we rational, calculators. Of our own self-interest, if you believe that you can believe the pigs will fly it's, a bitter scientific. Debate that, has real-world consequences let's, talk about the speed with which we are watching this market the crash of 2008. Nearly collapses. The global economy. The. Crash really matters it is unexplained. By the discipline, of economics it's just an insult a pointless, insult, the, set of amazing, experiments. Reveals it, was no surprise it was driven, by a psychology. Experiments. Show our behavior, is bizarre when, it comes to money it's, an almost irresistible force. But, not everyone, agrees the, observation. That people feel, emotions, means nothing. What. Happens when, two powerful, forces, collide, emotion. Still drives the markets mind, over. Money, right. Now on, Nova. Major. Funding for Nova is provided by, the following. Okay. Ready. It's an unusual, experiment, the challenges all our ideas about money, you want the bed an, auction. Of a $20, bill. $1. So, I hear $2 he's got $2, do I hear 3. 3. In the back I'm a four how, about five five. Five six. The, rules are simple the. Highest bidder will, get the $20, bill. But. There's a catch, the. Second, highest bidder receives nothing but, pains the amount of the losing bit right here 20. Amazingly. Two, participants. Bid way above, the face value a 626. 28. 28. So. Why would anyone pay more than $20. For a $20, bill a. Group. Of scientists, called behavioral, economists, think, they have the answer. They. Believe that when it comes to making decisions about, money the human mind often behaves, irrationally. 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. 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. 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 individual. Level and that's. A theory we rely on so. What is economics University. Of Chicago professor john cochran is another leading proponent, of this rational. Model of economics, 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's a model first revealed 200. Years ago by. The father of economics, Adam. Smith, in his, book Wealth of Nations 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-interests. Could coordinate, in markets, and produce, wonderful, outcomes. 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. Vanna. Smith basically, said people are rational and selfish. Very. Narrow for rationality. 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 or an invisible, hand that, keeps the hold economy, stable. He. Put it all together he, ended up with results that, are very modern, I mean you know II Congress over, the years have. Modified. It a bit but. Annasmith really had the basic. Insight we. Put those behaviors, together, in mark two centuries, later economics. Has evolved, into a rigorous, discipline. Having. Understood behavior. Having, thought about the markets where people interact with each other we.
Understand, The. Predictions, of that model, for the facts. And. Smith's. Insights, into how rational people make, financial decisions. Are now, expressed, in precise, mathematical, equations. Starting. After World War Two, increasingly. In economics, you had to say it mathematically if you were going to be taken seriously. Economics. From the very beginning had been pretty, much the study of rational. Greedy people making. Decisions to try to enrich themselves and, it, turns out that you can come. Up with some pretty elegant ways of expressing that mathematically. Today. These, mathematical. Models are the main tools used by economists, to, shape policies, that affect us all from. The interest rate 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. They. Represent, people as, doing, immense. Calculations. With immense. Databases. 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 compete our pleasure over time after, buying something. 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. Rational. Economists, concede, that people, don't actually do, these calculations. But. They have a well-known, defense as, if. The, way economics, textbooks, are written they don't say people behave this way they. Say people behave as if they, were doing this now, when we do that 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, behavioral. Economists, like Richard Thaler are unconvinced. Defending. Economic, theory, economists. Made a point about expert, billiards, players but, they might not know anything, about physics, or trigonometry, but they play as if, they do, now. That's ridiculous, you know 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 suppose, I want to make put this ball in this pocket now, I know the, trigonometry. I 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. All closed, most. Of the time we're not expert, billiards, players when, people, face hard problems, they make mistakes. 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 everyday, consumer market, and, in. The giant money markets, of Wall Street. Rational. Economists, believe that the increase, in wealth worldwide. Over, the last thirty years is. A triumph, for free markets, and. Lifted, maybe. A billion. People at a real poverty, and I mean real poverty, they have one dollar a day or two dollars a day that's real poverty, and the list of those people above them those women. Comes. The crash of 2008. The. Stock market drops over 40%. And. Apparently, irrational. Financial, behavior, becomes, the order of the day let's talk about the speed with which we are watching this market deteriorate, 14.
Trillion, Dollars, of wealth invested, by Americans, is destroyed, this has truly been a Manic, Monday on, Wall Street fear grips, the markets the stock market suffered one of its worst days in year and financial, experts are forced to imagine, the once impossible, we haven't seen anything like this since the great different local who come. To a halt I shudder. To think, all. Of that stuff. The. Consequences. Are beyond. Imagination. There, would be. Hunger. There would be war. There. Would be strife. There. Would be, total. Unemployment. We were having an electronic. Run, on the banks, it would put the world back a. Hundred. Years maybe, more. The. Chaos seems to undermine decades, of, economic thinking. Tarnish, there's a whole didn't, see it coming so that's a black mark on economics. And it's, not a very good mark from. The market, this, market took five years to, go higher, it's now down 40%. With. The crash the rift in economics, widens, between, the rationalists, and the behaviorists. Financial. Army, crash, really, matters because, much. Of the behavior that led up to the crash is unexplained, by. The discipline. Of economics I'm. Sorry this is just an empty argument that's. Just an insult a pointless. Insult. But. I don't see, this as a failure of economics, but we, need a whipping boy the, economists, have always kind of been working boys so they used to it it's fine. So. Which side is right are, we rational, about money. Or. Do our emotions. And psychology. Play, a much bigger role than previously. Realized. Take. The auction of the $20, bill that's sold for 28. In. The rational, model a person should never pay $28. For a $20, bill. Paying. More than something is worth cannot, be in any ways best financial, interest. The. Option, is a key experimental. For behavioral, economists. It's. Designed, to be a trap and it's. It's a trap that if you don't think more. Than a couple steps ahead you fall, into. It's. The emotional, desire to win that drives bids up, 14. 15. Divided here 20 and, the fear of being the loser that drives them even, higher. And. Now it's, a game of chicken. $20, sold for 28. And. You. Only $27, as well. Nobody. Will want to play that game twice. The. Auction may seem far removed from everyday life but. To people outside of the classroom, behave just, as irrationally. We. Ask shoppers, in a Chicago mall if they would prefer $100, in a year's time or. 102. In a year and a day I'll, take the hundred to two dollars in a year one day 102. Dollars here, plus a day and then I can wait that extra day for the. I'd really wanna make me a difference I would do the hundred or two a year a day from them they all made, the rational, decision what one day after a whole year waiting and chose the larger 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, take, the hundred dollars, right now I would take $100 tonight I'll. Prefer the honey girls today today. I'm. Taking $100, today the desire for a quick reward, $100. Today Trump's. Their rational, self-interest. There's. Something, called present, bias. That. If. We have the option, of something right now. It's. Very tempting to go for. 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. In. This experiment. Students, are asked to bid for a bottle of wine. 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've been influenced, by a completely, irrelevant. It. Is a great, illustration of, anchor, 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.
Do. Experiments. Like these expose, flaws in the assumptions, underlying. Rationale, economics. Dead. 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 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. For. Economists, like Cochran 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 all, right. When. I started, our technology. Was electric, lights and telephones and, that was pretty much it and. Yet. It's. Still the, same job try to anticipate, where. The stock is going to move over the next few seconds, or minutes and judge. Your trading decision supporting it and if, I'm right and, I. Buy a stock in anticipation, of other. People. Deciding. That this stock is under price then, I'll realize the problem. Now. The stock, exchange, is one small cog in a vast global machine, that's the financial markets. Technology. Means trading could take place anywhere. At. Night 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. And. Just, as Adam Smith suggested. Traders. Here compete fiercely to make as much money as possible for their clients, and themselves. 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. 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. Higher. Giving, the Dow its best day in, 2005. Rationale, and economics, it seems as, delivery. Times. Are good and have been for years snake, market in many parts of the country right, now many think the long boom will continue, earnings, jumped almost eight our, economic, horizon, is as bright as it's been a long time but those in the housing, business. Economist. Robert Shiller is. Unconvinced. It, did seem to me that there was a complacency. And overriding. Feeling. Of normalcy, that this, can't be wrong he, thinks the boom is, a mirage, the, real estate market, has grown to new heights and new prices. He's worried about one thing in particular. Housing. Housing. Prices have gone up 6%, a year for, decades in, 2005. In some places they're, rising at 25%, this. Was very anomalous, performance. The idea, that, home prices always. Go up led. People to think that they had all found. Came. To a two-day expo hoping to learn how they could turn investments. In real estate, interpersonal. Rich Shiller believes, America. Is in the grip of an irrational, main. Evil. Still the strongest, outing, in, history I predicted. That it was likely to correct down and that it might cause a huge, financial, crisis, in a worldwide recession. In. A book tour that summer he, warns of the dangers The, Economist, Robert Shiller, is out with a new book titled, irrational. Exuberance it's, kind of a frame of mind that we get into when prices. Keep going up, and we see a lot of excitement that's. Irrational exuberant. Rational. Economists, dismiss, his warnings. What. Does irrational, exuberance mean, it's, a lovely buzzword, for, a.
View. That prices, are higher than Bob, Shiller thinks they ought to be Bob. Who's a friend, of mine has. Been consistently. Pessimistic. About. About. Prices. The. Debate about whether rising. House prices are, the result of a mania, or rational. Calculation. Intensifies. Where. The individual, household, was not being irrational. And 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. 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. The. US economy has weathered such episodes, before. Without. Experiencing. Significant, declines in the national, average level of home prices. 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. This. Confidence, isn't, just a shared hunch. It's. Based on the widely accepted, models of rational, economics. 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. In. 2005. The economic, models assumed, consumers, will make careful calculations. About their mortgages. Economists. Assume, we. Shouldn't worry about people, taking, out. 95, percent mortgages, or a hundred percent mortgages. Or trust. Me mortgages, because, they'll. Only take out those mortgages, if they have. Made all of the relevant calculations. Instead. As housing, prices soar, many, consumers, take out mortgages they. Cannot afford an, assumed. 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 do 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. I, started. Looking in the brain as I was interested in emotion, and, I was convinced, there must be something in there that, could give us a handle on emotion, psychologist. Brian Knutson, wants, to know how emotions, affect one of the oldest, parts of our brain that evolves, so long ago we share it with many creatures even. Lizards in. General the lower the area of the brain. The. Farther, back it goes in evolution, right so we, humans still have these subcortical, areas deep in the brain that are ancient. This, part of the brain is called the nucleus accumbens and. It. Gets triggered by the most primal human needs. From. The standpoint of survival, it makes a lot of sense that, natural, rewards like food and sags and so forth would activate, the circuit that makes you go out and get those rewards. This. Part of the brain plays a crucial role in drug addiction. Out. Of curiosity, Knutson tries to find things that excited, as much as the prospect of sex, and drugs. So. He asks, people to imagine they are about to receive. Some. Money. Once. We started using money we, found very reliable, activation, in these emotional, circuits, this. Suggests that 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. 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.
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. Its, really driven, by human, emotion. This. Linked with emotions, makes many rational economists. Reject. The idea of bubbles, I. Used. To think I knew what the word bubble, meant but I don't think I know what it means anymore I. Canceled. My subscription to, The Economist, because, the. Word bubble appears three times in every page there now I think it's just totally gratuitous it's. Mindless. Bubbles. Sound innocuous. But. Financial, journalist, Justin Fox has, studied their history, and discovered. What happens, when, they burst. The. First financial bubble, involves, something highly, unlikely. 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 work shops and set up business, as florists. They call themselves even, for the most part but they really were were tulip, bulb traders, and it was a real financial market the price, of tulips, in Holland, rose to such a level that the value, of one tool involved, but sometimes be the same as that of an entire, house. Over. A three-year, period the, price of tulip bulbs rose and, rose and then, began. To soar, by. Some accounts almost, half the money in the Dutch economy was. Caught up in trades involving tulips. -. A lot of historians this is really the first example, of a financial bubble even though it was basically, tulips, 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 On, February. 5th. 16:37. The, most expensive, bulb, in Holland failed, to sell and tulip. Investors, panicked. Then. It burst because, prices start falling and then they're falling, more, and then you start thinking you, know I remembered, 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, as. The prices plunged leading. Citizens, found themselves bankrupt. Some. Historians, estimated. 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, 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 new, era. Observers. Described, feverish, emotions, as thousands, of investors paid ever higher prices, for stocks. And. In. So-called, Roaring, Twenties the stock market went through an enormous bubble. People. Thought it would never end. 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. It. Led to a depression, that lasted over. 10 years we. Had 25 percent unemployment for most of the decade of, the 1930s. It. Was a debt. That was driven by a real change in people's, psychology. That. Led them to be very optimistic and, positive in the 20s and then negative in the 30s. 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. Keynes. Believed, financial, markets arrived at prices in a pretty crazy fashion, his, classic, quote is that the market can stay irrational, longer than you can stay solvent. 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. Hannes. Never. Got past with fuzzy stage and, it, didn't, lead him to a precise, mathematical model. And that's why ultimately Keynes. Was rejected, by the profession. 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 we are interested in how much you would pay for this mug or one identical, to it these students have been told to work out the price of a common consumer item catalog and beautiful, maroon they're, asked first what they would be prepared to pay to buy the my 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. They. Offer an average of six dollars, so. We now have six of these mugs we're just gonna raffle them off by selecting. A few people at random 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 wanted to sell the mug back once you had it you gave a higher price, it. Just made, it seem a little bit more special, because it was it was gonna be something useful to me. Well I got this mug by complete. Luck. And so it's important to me and I have to charge this much for the emotional, pleasure of owning something for just an hour push, the price up by. 50%. It's. An unexpected outcome. Suggesting. We're unaware, of the emotions, that drive is behavior. At. Harvard, researchers. Are exploring the financial, impact, of these subtle influences. The. Team is led by Jennifer. Lerner I'm a social, psychologist not, a clinical psychologist, I, don't do counseling. Therapy, at 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. Lerner. Explores, all sorts, of emotions, today. It's sadness, and how, it impacts, financial. Decisions. The. Experiment, is designed to induce emotions, at such a low level, subjects. Aren't aware of them so, the, researchers, use sensors, to track the physiological. Effects of the emotion, now we're gonna get ready to collect the first alive example, from. Heart and breathing rate to. The hormones, in saliva. These. Are, physiological. Signals for, the subjects when we have them first come in they, sit and have a period, of quiet rest, relaxing, 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. 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. The. Decision, makers in our studies are completely, unaware that the. Sadness is infecting, them and when we ask them did. The film you saw, change. Your responses, in any way they, say no. It's. Time for the financial, tests. 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. Here's. An example the, 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 ten dollars to. Obtain. The water bottle and that. Is very representative, of what, we see that this increased, valuation. When you're sad if. Sadness, can lead people to pay four times more, for a water bottle what. Happens when, the stakes are higher. The. Experiments. Have been done with. High, stakes money thousand, dollars etc, and what we find is that these results scale, up even, when you use big. Money. 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, 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 I know what, you're experiencing. Because it's in my, body. - the same, feeling. That you have. If. Sheila is right could, empathy, explain, how the hyper optimism. Of the housing market jumped. Like a social, contagion, to the financial, markets. Among. Professional, traders the idea that moods flow, through markets, is taken, for granted 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 our people optimistic. Or are they pessimistic, and that's a psychological. Question. Emotion. Still, drives the markets for. Rationalist. Emotions. Are not a satisfactory. Explanation for. How markets, work. The, observation. That people, feel. Emotions, means nothing, and if. You're gonna just say Oh markets, went up because there was a wave of emotion, you got nothing, that doesn't tell us anything about what, circumstances.
Are Likely to make markets go up and down that that, would not be a scientific, theory. 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. Efficient-market. Can, exist, side, by side with irrational behavior, as long as you have enough. Rational. People to. Bring prices in and why, 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. It's. A pretty good model therefore, almost every practical, use she would put that model - it, worked pretty well. They. Created a big fuss and, the first persistence, of this day the. Fuss persists. Because for many behavioral, lists the theory implies financial. Markets, should, be immune from criticism or, control. The. Theory is that we, have to look at markets, as Oracle's. When. The market moves up we. Have to say what. Is the wisdom, of the market telling us today. 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. Instead. Of regulation, rationalist. Believe the markets, will come up with their own mechanisms. For managing, risk and so. They had. The. First was, invented here at the Chicago, Mercantile Exchange. Where. Traders handle, vast sums, of money all. The, time I'm. An independent trader and I trade, my own money 50. Contracts, to a hundred contracts, at a time but basically. A 50, million a hundred million dollars contract, side. Treaters. Here make their money by effectively, offering, to insure people against. Risk including. Agricultural. Producers, of pork, bellies and oranges. Long. Before this orange became an orange the. Farmer had to grow it well. He doesn't know what. Will be the price of that orange, when. It comes to the market finally done months later, will. He make a profit, as. Protection, farmers, take out contracts. To insure themselves against. The price of oranges dropping. Nowhere. In the market are you going to see an, orange, pass from one trader to, the next. Yep. Oranges. Were transacted, in, an invisible. Market, that. Is to risk transfer. Mechanism. 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, 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 Mohammed you're gonna take this exchange and blow, it up if. You're worried that a financial, asset like the currency, might suddenly move down you, can buy a derivative that pays you if that happens. Everyone. In the world uses. One or another form of financial. Derivatives to insure the. Risks that they have 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 ensure the risks of issuing, millions, of home mortgages. But. As all these different, risks grow, someone, has to measure them. At. Modern temples of finance the atmosphere, is less Chicago, mercantil, and more, like academia. No. Wonder, the, average trader here is likely to have a graduate, degree in math, the.
Culture Of trading has changed, when. I started in this business which, wasn't that long ago and 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. 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. There. Are still aspects, of trading that are an art and not a science what's. Changed is that they're now a lot of aspects that are are treated, as a science, and that's new over the last 20 years a client. Will troll. Through, tons. Of tons of data looking, for patterns and they're, crunching the numbers all day and china, improve. Performance, these. Two key innovations. Derivatives. To manage risk and, mathematics. To measure it convinced. Many that markets are efficient, making bubbles and crashes a thing, of the past, 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. Often. Their ivory towers. Jeremy. Grantham is a highly successful investor. For, the last 40 years he's, made his money by spotting, bubbles and betting. The prices will return to normal, we, found 27. Bubbles. Grantham. Believes bubbles, are inevitable, and have. A predictable, rhythm. Its. 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. Lemmings. Had in the opposite direction a. Chapman. University in, California, this cycle is studied by Vernon, Smith. A lot, of economists do not like the idea of bubbles because they're so hard to understand. In. This experiment. Smith wants to see what happens when students, compete, to earn money on a simulated. Trading for an experiment. It's not a classroom setting it's, a setting in which your. Job is to make as much money as you possibly can. If. They play the game well they could earn hundreds, of dollars, this. Is real money serious. Money, each. Of them has been given an imaginary, financial, asset, to Train 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. And. The, question, is whether, this. Will determine the, prices at which they exchange. Or whether they prices at which they trade deviate. On. The. 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 is 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, so you notice the price of bear racing up in the hope of making profits, they now trade, high above, the real value, there's. Quite a friends here way above fundamental. Value in the, flurry of buying the. Students, are now ignoring the fact that the asset will soon be worthless. We're. In a period 10, at. The end of period 15 these, assets are worth nothing. 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. 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, but I'm in an experiment, they gave us a magnificent, bubble. 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. And. Every time you created one you could make, 6%, of the total value you create, this. Was like a goldmine. 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, 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 it. Was essentially, assuming that there was no, more economic. Cycle notice, all those for sale signs out there on how they owe when. Home values, fall the model breaks down. The. Price of derivatives, plunges. Leaving. Financial, institutions. With billions, of dollars. Banks, couldn't sell these things at any price so, effectively. The. Price was not a financial. Meltdown, on wall on the eve of the crash there's, a whole intellectual. Edifice, built, on the assumptions, of, rational. Decision-making. It's. Really hard to say that the, market is rational, and perfect in those littles doing when it's clearly, capable of freezing, up and ceasing, to function. As fear, grips, the market, financial. Firms pull, back their money. And. Refuse to lend to each other. Uncertainty. Leads, to something that looks very much, like, panic. You. Can give it the charged, word panic, if you like but my view it's just a change in taste a trillion.
Dollars In investments. Have gone bad motions, is how human, beings make rational, decisions you. Know it's a 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. You. Take, this we have another, 30 years like we had them in the past including, this recession this would be a great achievement for the world those, of us who have looked to the self-interest, of lending institutions. Are in, a state of shock disbelief. 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. This, nova program is available on, DVD at. Shop PBS, org, or, call 1-800. Play PBS. You.