JOE NOCERA ESSAY

Sometimes I think we must be living in some kind of nightmarish, upside-down version of “Back to the Future.” It can’t possibly be that in the sophisticated 21st century, we find ourselves experiencing the same kind of financial panic that has dogged mankind at least since the Dutch tulip mania of the 1630s. Can it?
We look at those other eras - Dutch tulips and the South Sea bubble, the panics of 1825 and 1907, the crash of 1929 - and they seem so predictable in retrospect. They were marked by years of speculative excess, by financial innovation that got out of control and by mammoth asset bubbles that seem incredibly obvious in hindsight. There had to be a crash. It was all so unsustainable! Isaac Newton is said to have lost his life’s savings during the South Sea bubble. We think to ourselves, “A smart guy like that should have known better.”
And yet here we are. Every financial instrument relied on by investors - with the possible exception of Treasury bills - remains under severe pressure. Someday, when the history books are written, the inevitability of this crash - following speculative excess, Frankenstein- like financial engineering and a huge asset bubble - will seem every bit as obvious to future generations as the South Sea crash seems to us.
So why didn’t we know any better? Why do we, as a species, continually have these bouts of financial insanity?
“What does humanity ever learn about romance?” said James Grant, editor of Grant’s Interest Rate Observer and the author of the forthcoming book “Mr. Market Miscalculates.” Science, said Mr. Grant, is a discipline that builds cumulatively. Previous knowledge isn’t cast aside - it is built upon. But finance isn’t like that.
“People keep on stepping on the same rakes because money, like romance, is only partly an intellectual experience,” Mr. Grant continued. “Money, like sex, brings out some thought - but also much heavy breathing and little stored knowledge. In finance, the process is cyclical. Some people learn from their ancestors, but mostly they repeat the same mistakes. ”
Mr. Grant’s point, echoed by almost everyone I spoke to, is that it is not just the analytical part of our brain that deals with money, it is also the instinctive, emotional part - what we like to think of as our gut. A lot of the time, our gut gets it wrong. And that is as true of highpowered investment bankers as it is of smaller investors.
Paul Slovic of the University of Oregon, an expert in the psychology of risk, pointed out that when times are good, “the sense of risk is depressed. You don’t look as hard for warning signs.” Robert Shiller, a Yale University economist, said, “One thing we know about human behavior is that our memory is influenced by recent events.”
Thus, when we are living through a housing bubble, it is hard not to be caught up, emotionally, in the idea that prices can only go up - even though our analytical brain knows that acting on such impulses defies logic. But in the moment, a kind of unshakable euphoria takes over, and we just can’t imagine its ever ending. Similarly, when times are bad, fear and loathing capture our imagination, and we find it equally impossible to see a glimmer of hope. We take actions to protect ourselves even though these individual actions result in a kind of cumulative madness.
But while history may help us understand why financial panics take place, it doesn’t do anything to prevent them. The impulses that make us want to forgo the slow and steady for instant riches, that cause us to go along with the crowd instead of bucking it, that allow us to think that this time it’s different, instead of understanding that it never is - these are such basic aspects of human nature that they cannot be changed through study alone.