Here is an excerpt from an article which throws some light on the causes of bubbles in finance. Clever people take advantage of human brain flaw and succeed in creating bubbles and bubble are destined to burst, which is as sure as daylight.
Why are bubbles such a persistent feature of financial history? Economists argue that these speculative frenzies are caused in part by market failures like too much liquidity or lax regulation. Cognitive psychologists, meanwhile, see bubbles as a case of pattern recognition gone awry, as people extrapolate the past into the future. In recent years, neuroscientists also have become interested in bubbles, if only because the financial manias seem to take advantage of deep-seated human flaws; the market fails only because the brain fails first. Read Montague, at Baylor College of Medicine, has spent the last few years trying to decipher the bits of brain behind our irrational exuberance. It’s microeconomics at its most microscopic.
At first, Montague’s data confirmed the obvious: our brains crave reward. He watched as a cluster of neurons acted like greedy information processors, firing rapidly as the subjects tried to maximize their profits during the early phases of the bubble. When share prices kept going up, these brain cells poured dopamine into the caudate nucleus, which increased the subjects’ excitement and led them to pour more money into the market. The bubble was building.
But then Montague discovered something strange. As the market continued to rise, these same neurons significantly reduced their rate of firing. “It’s as if the cells were getting anxious,” Montague says. “They knew something wasn’t right.” And then, just before the bubble burst, these neurons typically stopped firing altogether. In many respects, these dopamine neurons seem to be acting like an internal thermostat, shutting off when the market starts to overheat. Unfortunately, the rest of the brain is too captivated by the profits to care: instead of heeding the warning, the brain obeys the urges of so-called higher regions, like the prefrontal cortex, which are busy coming up with all sorts of reasons that the market will never decline. In other words, our primal emotions are acting rationally, while those rational circuits are contributing to the mass irrationality.
Unfortunately this tendency is exacerbated by other people. Montague has also found, for instance, that subjects in the investment game are extremely vulnerable to what he calls “the country-club effect,” which occurs when we try to make more money than someone else. “This is what happens when you’re sitting around with your friends at the country club or watching cable TV, and everybody is talking about their huge profits,” he says. “Those conversations are going to change the way you think about risk.” Men seem especially vulnerable to this foible: When they competed against strangers, they were much more likely to get swept away by the financial speculation.
