Swept Up by Insanity of Markets 
Excerpt:
“I can calculate the motions of heavenly bodies, but not the madness of people.” — Isaac Newton, 1721, after the South Sea bubble burst.
Sometimes I think we must be living in a movie, some kind of nightmarish, upside-down version of “Back to the Future.” It can’t possibly be that in the sophisticated, computerized 21st century, we find ourselves experiencing the same kind of financial panic — the same kind of financial insanity, really — 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. Iceland is bankrupt. European banks are teetering. Barely a week after the federal government passed a $700 billion rescue plan that revolved around the sale of toxic assets from financial institutions to the government, the Treasury Department announced it would focus its attention on a new plan to inject capital directly into the banks that most needed it. That is now supposed to be the thing that rescues the banking system…
…So why didn’t we know any better? Why do we, as a species, continually have these bouts of financial insanity? This week, with the markets collapsing, that was what I most wanted to understand.
“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 forgotten or 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. Thus it has always been and thus it will always be.”
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 high-powered investment bankers as it is of mom-and-pop investors.
…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.
They can be changed only by cold, painful experience…
Mr. Shiller, a leader in the field of behavioral economics, believes that bubbles and crashes are a kind of social epidemic. “Ideas become contagion,” he said. When housing prices were rising quickly in the early part of this century, he said, “people misinterpreted the meaning of the price increase. The theory that housing prices could only go up began to sound plausible. It became a thought virus. And people believed it was true rather than realizing it was a thought epidemic.”
Crashes tend to feed on a similar dynamic, except in reverse. Mr. Shiller did a study of the days leading up to Black Monday in 1987 — days that also had sharp market drops — asking people what they were reading and talking about. Invariably, they were reading and talking about the big price drops, which led them to pull money from the market, which led to yet more price drops. “Exactly the same thing is happening now,” he said…
…All around me, I hear the sounds of panic. Some things, it turns out, never change."
Full article here.
