No, I am not talking about soap bubbles or a bubbly mood. I am also not referring to the bubble the 1% live in, but that’s getting closer. What I am talking about are financial bubbles, like the kind that sank the U.S. economy in 2008 and for which millions of people are still paying the price.


Nothing new under the sun

Extraordinary Popular Delusions and The Madness of Crowdsis a history of popular folly by Scottish journalist Charles Mackay, first published in 1841. The first recorded financial bubble was the 1637-1638 tulip bubble in the Netherlands. For some obscure reason, the price of tulips started rising, then soaring. By 1636, the tulip bulb became the fourth leading export product of the Netherlands, after gin, herring, and cheese. The price of tulips skyrocketed because of speculation in tulip futures among people who never saw the bulbs. Tulip mania reached its peak during the winter of 1636–1637 when some bulbs were reportedly changing hands ten times in a day. No deliveries were ever made to fulfill any of these contracts, because, in February 1637, tulip bulb contract prices collapsed abruptly and the trade of tulips grounded to a halt. People lost fortunes overnight and the Dutch economy struggled for a long time after the collapse.


The South Sea Company

The South Sea Company was formed in 1711. The company was promised a monopoly of all trade to the Spanish colonies in South America in exchange for taking over and consolidating the national debt raised by the War of Spanish Succession (1701-1714). In January of 1720, South Sea Company stock was trading at a modest £128. Investor mania developed and, by May, it was at £550. By the end of June, its share price had spiked to a peak of £1050. Investor confidence began to wane, however. The sell-off began by early July and the collapse occurred quickly. By the end of August, stock was valued at less than £800. By September, the share price had plummeted to £175, devastating institutions and individuals alike. In 1721, formal investigations exposed a web of deceit, corruption, and bribery that led to the prosecution of many of the major players in the crisis, including both company and government officials.


John Law and the Mississippi Bubble: 1718-1720

John LawJohn Law was a Scottish bon vivant (a Scot???) and a gambler, who befriended the Duke d’Orleans, the French Regent of Louis XV. Through this connection, he established a trading company, Compagnie des Indes (“Company of the Indies”), that by 1719 held a complete monopoly of France’s colonial trade. Law also took over the collection of French taxes and the minting of money; in effect, he controlled both the country’s foreign trade and its finances.

Given the potential for profits involved, public demand for shares in the Compagnie des Indes increased sharply, sending the price for a share from 500 to 18,000 livres, which was out of all proportion to earnings. A frenzy of wild speculation ensued that led to a general stock-market boom across Europe. The end was predictable: the expected profits from the company’s colonial ventures were slow to materialize and the intricate linking of the company’s stock with the state’s finances ended in complete disaster in 1720, when the value of the shares plummeted, causing a general stock market crash in France and other countries.


More recent bubbles

In the 1920’s, the U.S. stock market soared. But in October 1929, the market collapsed and the Great Depression ensued with horrendous economic and social consequences.

Fast forward to the year 2000. This is the year when the craze seized Wall Street. Prices reached nose-bleed heights, beyond any rational level. “This time is different,” was the mantra of the financial soothsayers. Indeed, it was until it wasn’t. In October 2000, prices collapsed. simply disappeared. Cisco, a real company with real assets and real business, plunged 88% within days. Amazon went from $107 to $7.

If you don’t remember these events, surely, you remember the collapse of the financial system in 2008 because of the banks’ speculation in sub-prime home mortgages. The result? The Great Recession—its echoes still reverberate in today’s economy.

You’d expect that such momentous failures on the heels of rank speculation, which caused the destruction of national economies and impoverishment of millions lasting decades, that we would learn a lesson. But neither investors nor regulators charged with spotting and avoiding future financial debacles learned anything.

Surely, we are not that stupid. We learn from engineering errors and correct them. We learn from scientific failures and avoid repeating them. We learn from failed social and political policies, or at least, try to learn from them. So what is it about financial follies that we keep repeating them? There must be something more “structural” about them that resists change. Indeed, Nobel laureate Daniel Kahneman, the father of behavioral Economics, has demonstrated that we are doomed to repeat past errors because we believe that “this time is different.”


When will they ever learn?

Neurobiology answers, “Probably never.” It looks like irrational exuberance is hard-wired in the brain. In a recent paper in the Proceedings of the National Academy of Sciences, neurobiologists from Caltech, Virginia Tech, and London University College set out to see what makes the difference between most people who get suckered in a financial bubble and those who are successful in avoiding it, laughing all the way to the bank. The study shows that activity in one area of the brain actually tracks price bubbles—and that higher earners get signals from a different area that are associated with selling before a price bubble peaks. It also showed that more successful traders got brain signals that told them to listen to their gut and sell before a bubble burst.

The study was conducted in 16 experimental trading sessions with 320 participants—mostly students at the University of California, Los Angeles. They went through 50 trading rounds. Two to three volunteers per session did the experiment while undergoing magnetic resonance imaging—lying on their backs in an MRI machine. All the traders knew that the value of the stock remained constant at $140. Yet, they could also see on their computer screens that trading pushed the price up. And so, they joined the party and bid the price even higher. The traders who had their brains monitored by fMRI while they were watching the prices going up and trading the rising stock price showed that their nucleus accumbens, an ancient part of the brain reward system, became highly active. So, in their brains, this area was actually watching the bubble develop, yet most of the traders merrily participated in its further inflation.

Nucleus accumbens-part of the reward system
Nucleus accumbens, part of the reward system

Most, but not all. About 20% of the traders got out of the market a few trading cycles before the bubble burst. What was different about them? In an evolutionary relatively newer area of the brain called the anterior insular cortex, (which is active during bodily discomfort and unpleasant emotional states, such as pain, anxiety and disgust; in other words, what we call “gut feeling”), the signal got progressively stronger and the successful traders listened to it.

They were not scared to trade; they participated in the trades initially. The difference is that their anterior insula sent strong enough signals to counteract the exuberance of the nucleus accumbens when the latter became, well, irrational. And, when a large enough number of them sell, they are the ones who cause the bubble to burst. Speaking of self-fulfilling prophecies…


What if you are not trading in stocks?

Should you care? You bet. Research has indicated that the nucleus accumbens has an important role in pleasure including laughterreward, and reinforcement learning, as well as fear, aggression, impulsivity, addiction, and the placebo effect. So, much of our behavior is controlled by this nucleus and its modulation by the anterior insula.

Of course, we cannot cede control of our behavior to the nucleus accumbens or to any other brain structure. We can punish the wrongdoers who perpetrate such ruinous schemes, and we should. But ultimately, it is our responsibility to recognize our own vulnerabilities so that housing bubbles, technology bubbles, financial bubbles, and bubbles of any sort will not form in the first place. In the last analysis comes one thing: education and informed citizenry.

This opens new pathways for research into controlling irrational or otherwise harmful behavior. Can you foresee a day when our Congressional representatives receive a small chip imbedded in their right anterior insula as a part of their swearing in ceremony?

First published on 7/13/14, this post was updated on 2/22/16 in honor of the release of the movie, The Big Short, that so entertainingly portrayed the 2007-8 financial collapse sparked by the bursting of the sub-prime mortgage bubble.

Dov Michaeli, MD, PhD
Dov Michaeli, MD, PhD loves to write about the brain and human behavior as well as translate complicated basic science concepts into entertainment for the rest of us. He was a professor at the University of California San Francisco before leaving to enter the world of biotech. He served as the Chief Medical Officer of biotech companies, including Aphton Corporation. He also founded and served as the CEO of Madah Medica, an early stage biotech company developing products to improve post-surgical pain control. He is now retired and enjoys working out, following the stock market, travelling the world, and, of course, writing for TDWI.


  1. Great post Dov. I’ve read the thrill of making money and the thrill of taking cocaine has the same affect on the brain. It’s only addictive to certain people. I’m not sure what area of the brain that is affected.


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