PRESTOPUNDIT

In virtually every area of markets, human behavior has economists stumped. "We don't know why stock prices go up and down," said Caltech economist Colin Camerer. "We don't know why savings rates are so dramatically different in different parts of the world. We don't know why there is labor market discrimination." People trust other people when economic theory says they should not. They cooperate when betrayal seems more rational. They gamble foolishly, overestimating risk when they are losing, and underestimating it when they are winning. They spend too much and save too little.

Economists know all this from personal experience, but they don't know how to factor the quirks of human behavior into their mathematical models. This is no small matter. Efforts to set interest rates, revamp health insurance, privatize Social Security, revise pensions, police the sale of securities and alter legal liability rules rely to some degree on economists' ability to make reliable predictions about the choices people will make ..

For the trust experiment, funded by the Brown Foundation Inc. in Houston, the researchers often paired a volunteer in a brain scanner at Baylor with one at Caltech, more than 1,300 miles away. The researchers at Baylor and Caltech have conducted the experiment with 144 people — the largest interactive brain-imaging study ever.

So little is known about the biology of decision-making that researchers had no theory to test. They wanted to gather as much data as possible during the financial interactions in the hope that signatures of brain activity might emerge. "In this game, trust builds up, and it must exist somewhere in the brain," said Caltech neuroscientist Cedric Anen. "But there is not one event where we can say, 'That is trust.' We don't know when it starts, how it builds up or what is involved."

The results, so far unpublished, reveal that financial dealings seem to engage neural networks in the cingulate cortex, an area of the brain involved in switching between tasks, monitoring errors and short-term memory. In sprays of light on a computer screen, the researchers could see how levels of activity shifted. Men typically showed the greatest activity in the seconds before making an investment decision, women in the moments before they revealed their decision to their trading partner ..

"Trust is one of those few notions that underlies everything from individuals making decisions together to huge policy questions between nations," said Steve Quartz, director of Caltech's social cognitive neuroscience laboratory. "For a long time, we thought this was a state beyond measurement. "The brain scanner is beginning now to put a yardstick up against it, to provide a measure for it."

In deconstructing the biology of trust, other researchers have determined that the brain appears to prize that bond between two people biochemically, secreting a powerful hormone to cement working relationships. The act of trust correlates with elevated levels of a brain hormone called oxytocin, the same chemical released during breast-feeding and uterine contractions, according to experiments done by researchers at Claremont Graduate University.

"It literally feels good to cooperate," said Paul J. Zak, director of the Center for Neuroeconomics Studies at Claremont. As the hormone level rose, people also were more likely to reciprocate trust. "The stronger the trust, the more the oxytocin went up, and the more trustworthy you were.

"Interestingly, participants in this experiment were unable to articulate why they behaved the way they did," Zak said. "But nonetheless their brains guided them to behave in 'socially desirable' ways — that is, to be trustworthy." ..

When a decision forms, the brain moves faster than self-awareness. The brain unconsciously prepares to act a measurable length of time — up to 500 milliseconds — before a person consciously decides to act. In other words, the brain is always one step ahead of itself, calculating the potential costs and benefits of each choice at a cellular level.

"Most of the brain is dominated by automatic processes, rather than deliberative [thinking]. A lot of what happens in the brain is emotional, not cognitive," said George Loewenstein, a behavioral economist at Carnegie Mellon University.

Some brain cells are especially sensitive to the potential rewards of decisions, research at Baylor and Emory University suggests. Brain cells that release a chemical called dopamine, which serves as a reward to reinforce behavior, actually anticipate snap decisions to help balance costs and payoffs. The cells secrete a burst of good feeling beforehand to underline the desirability of one course of action versus another. These neurons respond selectively. Some react only to the possibility of something beneficial and others only to the reward itself, researchers at the University of Fribourg in Switzerland discovered.

Every brain is of two minds about the future. Two competing neural systems interact during choices that hinge on a conflict between short-term and long-term benefits, Harvard University researchers reported. "Our emotional brain has a hard time imagining the future, even though our logical brain clearly sees the future consequences of our current actions," said Harvard economist David Laibson. "Our emotional brain wants to max out the credit card, even though our logical brain knows we should save for retirement."

Moral dilemmas can engage the same sense of fair dealing and mutual obligation as money matters. Researchers at Princeton University determined that synapses active during complex moral choices tapped into areas associated with rational thinking — and also into regions aroused by strong emotion. "Some of that emotional architecture affects decisions we make involving money," Zak said.

Critics have often argued that volunteers playing experimental games in brain scanners are no measure of real market behavior. So researchers led by Lo at MIT studied working traders during their normal business day. To measure brain activity indirectly, he wired 10 currency speculators at a Boston brokerage to sensors monitoring heart rate, breathing, blood pressure, body temperature and skin conductivity. By the end of the day, the traders had made 1,200 split-second trades, averaging $3 million to $5 million apiece.

His team plotted the biological indicators of stress, exuberance and tension against real-time profit and loss. He repeated the experiment at the Boston Stock Exchange. Market trades, the sensors showed, were the stuff of sweaty palms, heavy breathing and pounding pulses. Snap judgments, honed by intuition, outweighed high-minded economic calculations. These were "gut" decisions. Contrary to traditional economics — which considers only rational deliberation — such measures of market panic and exultation begin to document how involuntary emotions affect the rise and fall of stocks.

Already, preliminary findings about the balance sheet of the brain have scholars rethinking the meaning of money itself. The same reward circuitry activated by cocaine, sports cars, attractive faces and jokes is activated by money. Until now, economists have assumed that money was prized not for itself but only for what it could buy. Moreover, the prospect of winning money activates specific brain regions in a way that the threat of losing it does not, researchers at Stanford University recently demonstrated.

Scientists are not sure how the electrical snap of synapses adds up to a financial decision, or how these insights might be assembled into a working theory of economic behavior. "Sooner or later, you have to engage the issue of free will," said Glimcher, the New York University scientist. "When we finally understand the human brain, all human behavior will be predictable."

Decisions, Uncertainty, and the Brain : The Science of Neuroeconomics by Paul Glimcher

Behavioral Game Theory : Experiments in Strategic Interaction by Colin Camerer

Liars, Lovers, and Heroes: What the New Brain Science Reveals About How We Become Who We Are by Steven Quartz &Terrence J. Sejnowski

The Psychology of Economic Decisions (vol. 1) edited by Isabelle Brocas & Juan Carrillo

Advances in Behavioral Economics edited by Colin Camerer, George Loewenstein & Matthew Rabin

The Psychology of Economic Decisions (vol II): Rationality and Well-Being edited by Isabelle Brocas & Juan D. Carrillo.