Of Laws, Lending, and Limbic Systems

Over the past four centuries, financial crises have occurred at semi-regular intervals of approximately once a decade. Their primary mechanism seems to be the increasingly elastic nature of credit in the modern financial system. Recent advances in neurophysiology and cognitive neuropsychology shed light on this phenomenon and provide hints about how such crises might be mitigated in the future.Financial theorist Hyman Minsky asserted that financial bubbles require two conditions: a trigger, or “displacement”—usually a technological or financial innovation—and abundant credit. In modern times, fractional reserve banking and its equivalents in the non-banking sector have provided the source of liquidity with which to inflate bubbles; and when at some later point credit is withdrawn, panic and crash ensue. Over the past century, lightly regulated “parallel banking systems” have become an increasingly important source of this instability.Minsky also divided capital operations into three classes: “hedging operations” that fund both interest and principal repayments through expected cash flows, “speculative operations” that fund interest but not principal, and “Ponzi operations” that fund neither. Charles Kindleberger listed no fewer than 46 panics and crashes in the world financial system over the past four centuries—approximately one every decade. Thus, the duration of the operations’ liabilities becomes critically important; the shorter the duration, the more vulnerable all operations, even the safest hedging ones, become to the inevitable credit disruptions associated with these events.Recent research in cognitive neuropsychology sheds some light on why both borrowers and lenders involve themselves in speculative and Ponzi operations: In all probability, the prospect of short-term financial reward stimulates the evolutionarily ancient neural circuitry of their rapidly reacting limbic systems. The limbic “greed center” seems to lie in a pair of structures known as the nuclei accumbens. Functional MRI studies show that these nuclei activate with the anticipation of multiple types of reward, including, but not limited to, financial gain and the consumption of addictive substances.During market bubbles, the aggregate stimulation of participants’ limbic systems overwhelms the aggregate of participants’ higher cortical function, the locus of rational, calculating market activity. The cohabitation of the mediation of drug addiction and of short-term financial reward in the limbic system has profound implications; this may help explain why market participants so soon forget the lessons of previous booms and busts.How, if at all, can financial regulation interrupt such neurophysiologically mediated dysfunctional market behavior? Unfortunately, history demonstrates that financial innovation usually races far ahead of the slower-moving regulatory apparatus. Nonetheless, regulation can succeed, as demonstrated by the nearly half-century period of stability and growth following the ensemble of New Deal securities legislation, which at the time was bitterly opposed by the financial industry.Whatever regulatory action is chosen, it should include four mechanisms not commonly considered to be part of the traditional apparatus:A discrete organization dedicated to economic history should be established. Economic history has a great deal to teach us about preventing future blowups; for example, in many aspects, the current crisis was very similar to the panic of 1907.Similarly, cognitive neuropsychological techniques to assess and monitor the degree of speculative behavior should be developed and deployed.An early warning system that tracks the systemic threats from novel financial instruments should be established and given robust enforcement authority.More attention should be given to the dangers of short-term financing in a world prone to periodic credit disruptions.