Alan Greenspan, former governor of the Federal Reserve, suggested in a recent piece in the Financial Times that the unknown factor that causes bubbles may be what the great economist John Maynard Keynes referred to as 'animal spirits'.
Animal spirits are the unquantifiable, irrational factor in human psychology that means humans do not always behave in line with rational economic models. This is how the Economist's dictionary defines the term:
The colourful name that Keynes gave to one of the essential ingredients of economic prosperity: confidence. According to Keynes, animal spirits are a particular sort of confidence, "naive optimism". He meant this in the sense that, for entrepreneurs in particular, "the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death". Where these animal spirits come from is something of a mystery.
Now, scientists claim to have unravelled the mystery as to the origin of these bestial impulses in our supposedly rational economies. A team at Cambridge University took blood samples of City traders after a particularly profitable day's trading, and after a particularly tough day.
They discovered that after a very good day's trading, make traders' blood showed high levels of testosterone, which (the team speculated) may have encouraged the traders to carry on taking risks even when it would have been wise to stop.
Likewise, after a bad day's trading, the traders' blood showed high levels of cortisol, the stress hormone, which may have made the traders unusually risk averse, even beyond the point where caution was required.
So the animal spirit behind a bull-run is testosterone, and the animal spirit behind a bear run is cortisol. So presumably in future downturns, rather than pumping billions of dollars into the financial system, regulators will simply pump gallons of testosterone onto City trading floors.
The report is an example of the increasingly popular attempt to bring together psychology and economics, which some people have called behavioural economics, and others have called psychoeconomics. I personally am very interested in psychoeconomics, and shall speak again of it shortly.