Uncertainty is Sometimes Better than Certainty

John_Coates_140701_vThe mental and physical overconfidence of economic operators might make a new crisis more dangerous than expected, says John Coates Professor of Neuroscience at the University of Cambridge and former securities trader for Goldman Sachs and Deutsche Bank. In his interview to alapblog.hu, he states that the predictability of the market environment, controlling central banks, and politicians negatively affects – not so much the psychological but – the physiological abilities of the market players. John Coates notes that the transparency and predictability of the environment, including partners and competitors, makes investors just as reckless as athletes or politicians.

Zentai Péter: Predictablility –what normal people want to be surrounded by. It is no accident that citizens and economic operators require predictability from their governments, politicians, and central banks.
However, you say that we might get into trouble, if the FED – the American central bank, perhaps the most influential policy-making institution – remains so foreseeable. Would you explain that?

John Coates: From 1945 to 1994, the decision making and the communication of the Federal Reserve System (FED) were completely “random”. In fact, the central bank deliberately did not want to tell people its biases, what it was doing, or what it was thinking. It kept the market in dark, which therefore, had to figure out whether it had raised rates or not by looking at the federal funds. The policy of forward guidance was begun in 1994 by Alan Greenspan. His monetary policy became very predictable: he gradually raised rates, changed operations in the FED, and announced these changes regularly. Since then, the FED has been increasingly open to the market, communicating all the actual and potential financial decisions; for instance, whether and how rapidly it is going to continue with its quantitative easing.

That is how it should be! The market operators should know where the line is. With this openness, the FED is able to discipline the market and reduce the likelihood of the occurrence of a sudden crisis, a sudden market crash. It contributes to stability because it creates a more predictably environment.

Well, we know that there have been a few serious market crashes until 1994 but they were not as severe and did not last as long as the ones in the last twenty years.

Are suggesting that the change in the more transparent communication of the FED might be blamed for that?

The most important player on the market, the American central bank, ignored the fact that the financial risk-taking is not purely a mental activity but a physiological one; it is linked to the biological processes of the people.

While I was working as a Wall Street trader at Goldman Sachs and Deutsche Bank, I started to study neuroscience and physiology, more specifically, the effect of the physical state of traders on their decisions of risk-taking.

It turns out that just as you can predict an athlete’s success in a tennis match by the state of his body, you can more or less predict the performance of a trader by the state of his body. When the volatility in the market picks up, when he is making above average profits, or when he is making above average losses, it is not just a cognitive but also a physical experience. Every time we use our brain, our body is used as well. Trading is a very physical activity; stress hormones, for example, determine the amount of risk you might be taking.

In the article of your research group published by the Proceedings of the National Academy of Sciences, you state that the more stressful a situation is, the more risk averse we become.

It is very important to distinguish between acute stressors (with a short-term effect) and chronic stressors (which last longer). The short-lived stressors are actually highly enjoyable, increase our creativity, and encourage us to undertake more risk. But when the stress response lasts longer than a certain amount of time, our elevated stress hormones can damage our health, harm our sleep, our behavior, and our mood. This is the kind of stress that makes traders to become risk averse in the financial markets and cause financial markets to freeze up.

Now, we see the exact opposite of this situation. Everybody is buying and the stock prices rise rapidly.

Complacency has increased in the market – in effect, due to the market-friendly and predictable policy of the FED. The traders, investors, and economic decision-makers are becoming way too over-confident and reckless. There is a danger that the bubble will blow up.

Does the predictability of the competitors, in general, make people more reckless? Is it also true for an athlete or for a politician?

Absolutely. We have one biology for sports, for politics, for financial markets. The physiology in sports or in politics is identical to the one that is used in the financial markets. So the physical processes of risk taking that we found for traders, can be also found in athletes or politicians. The more confident they feel and the more predictable their environment is, the more risk they will undertake.

Could this tendency be stopped, if the FED and the other central banks became again more unpredictable?

It would definitely help, if the market operators started to fear again and their reckless, risk-taking behavior changed. If they felt more uncertain, they would not be under the illusion that the FED, other central banks, and politicians would do anything to save them in case of another dramatic market crash.