Our growing understanding of the physiology and chemistry of human behavior presents us with potentially universe-denting opportunities to hack ourselves and predict how others will behave in certain situations. For example, take a look at this recent New York Times article about the biology of risk:
When opportunities abound, a potent cocktail of dopamine — a neurotransmitter operating along the pleasure pathways of the brain — and testosterone encourages us to expand our risk taking, a physical transformation I refer to as “the hour between dog and wolf.” One such opportunity is a brief spike in market volatility, for this presents a chance to make money. But if volatility rises for a long period, the prolonged uncertainty leads us to subconsciously conclude that we no longer understand what is happening and then cortisol scales back our risk taking. In this way our risk taking calibrates to the amount of uncertainty and threat in the environment.
Under conditions of extreme volatility, such as a crisis, traders, investors and indeed whole companies can freeze up in risk aversion, and this helps push a bear market into a crash. Unfortunately, this risk aversion occurs at just the wrong time, for these crises are precisely when markets offer the most attractive opportunities, and when the economy most needs people to take risks. The real challenge for Wall Street, I now believe, is not so much fear and greed as it is these silent and large shifts in risk appetite.
Knowing this, our Federal Reserve could manipulate interest rates in ways that could prevent the boom and bust cycles that have so damaged our economy in recent years.
It has, in interest rate policy, not one tool but two: the level of rates and the uncertainty of rates. Given the sensitivity of risk preferences to uncertainty, the Fed could use policy uncertainty and a higher volatility of funds to selectively target risk taking in the financial community.
It may seem counterintuitive to use uncertainty to quell volatility. But a small amount of uncertainty surrounding short-term interest rates may act much like a vaccine immunizing the stock market against bubbles.
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