How US Federal Reserve Policies Stimulates the Public’s Speculative Behavior

In a book review, Douglas French, president of the Mises Institute, explains the physiological and psychological dimensions of how US Federal Reserve policies whets people’s appetite for speculation and gambling.

For the average Joe, the mere idea of making money fires the dopamine neurons in his brain, and because (crazy) people tend to herd, this leads investors to pile into the same investments at the same time, which happen to be investments that have done well in the past. Or in other words, investors gravitate en masse to investments that are overpriced. Merely watching the green arrows on CNBC stimulates dopamine.

So when the Fed hit the monetary gas in 2001, interest rates plunged and the lumpen investoriate collectively plunged into housing only to be massacred by the end of the decade. Before that, Greenspan's Fed lubricated the financial system thinking all kinds of things would go wrong at Y2K. The money sloshed into Internet stocks and investors piled in just in time to lose their shirts.

Dopamine neurons are stimulated only if the rewards exceed the expectation. If investments work as planned, even if the result is good, there will be no rush at reward. And when results are less than expected, dopamine neurons are depressed — creating immense regret.

As a real-estate developer told me in the early 2000s, "interest rates are so low, I have to do something." His brain was already feeling the dopamine tingle of anticipated profits by hearing of the lower rates. As Pavlov's dogs salivate at a bell that reliably signals food, low interest rates transformed investors into Greenspan's and now Bernanke's dogs.

Bernanke's zero-interest-rate policy has investors lunging for yield, buying junk bonds and junk houses. "The rally in junk bonds extends an advance that began in early 2009 and can be traced largely to the Federal Reserve's policy of keeping benchmark interest rates near zero," writes the Wall Street Journal's Matt Wirz. "A pretty robust cottage industry has developed and is absorbing [single family homes] at an incredibly fast pace," Richard Smith, chief executive of Realogy Corp., tells the WSJ.

To add insult to injury, Burnham points out that people are "systematically overconfident. We are bad at doing the calculations required to analyze investments, and simultaneously we are unaware of our shortcomings." And if this isn't bad enough, Burnham points out that numerous studies show that people "reveal themselves to be proud. They are willing to lose money to retain their self-esteem."

Of course this all flies in the face of the efficient-market hypothesis, which claims all market participants are rational, and therefore all news is priced into particular investments at any one time, and there is no such thing as a speculative bubble.

As he wound up his Atlanta speech, Burnham had some sobering thoughts. "Financial markets are the watering hole of society," he quipped. Like thirsty animals on the African Savannah, humans are attracted to the speculative gains that financial markets promise. But, stopping for a drink is likely hazardous to our financial health.

Incentives drives people’s actions. Yet policies plays a substantial role in influencing people’s incentives. What some see as inappropriate behavior (such as “speculation”) driven by individual character flaws, is in reality, mostly a reflection of people’s responses to such policies.

This simply shows that inflationism is immoral.