Theory of Mind and the mind of the market

The financial community has been in a striking tizzy over the fact that the Federal Reserve didn't do what they were predicting, i.e. start to dial back on their economic stimulus. The financial community also has not been very good at predicting or knowing when a financial bubble is growing. Perhaps work like this piece by Martino et al. casts some mechanistic light on this. They demonstrate that the ability to infer the intentions and mental states of other individuals (“theory of mind”) biases evaluation when people interact not with individuals but with complex modern institutions like financial markets, contributing to the formation of economics bubbles. Here is their summary:

The ability to infer intentions of other agents, called theory of mind (ToM), confers strong advantages for individuals in social situations. Here, we show that ToM can also be maladaptive when people interact with complex modern institutions like financial markets. We tested participants who were investing in an experimental bubble market, a situation in which the price of an asset is much higher than its underlying fundamental value. We describe a mechanism by which social signals computed in the dorsomedial prefrontal cortex affect value computations in ventromedial prefrontal cortex, thereby increasing an individual’s propensity to ‘ride’ financial bubbles and lose money. These regions compute a financial metric that signals variations in order flow intensity, prompting inference about other traders’ intentions. Our results suggest that incorporating inferences about the intentions of others when making value judgments in a complex financial market could lead to the formation of market bubbles.