Evolution and Financial Markets

I am way out of my league writing this post, but life is short and its fun to get ideas out there.

I was listening to one of those iTunesU podcasts about behavioral economics and I was moved to throw the following hypothesis out into the intrawebular ether. It's an explanatory hypothesis, and I can't figure out any useful predictions that it might make, but when has that ever stopped anyone before?

The idea is this: The boom and bust cycle of the markets is driven by an ingrained human tendency to barrel forward full bore when we and those around us have resources, and hoard resources when we and those around us have little. The key here is the social nature of the tendency, we don't just pay attention to our own resources, but also of the perception of the total resources available in the environment.

Furthermore, this tendency might be the result of evolutionary pressure. When the environment is perceived as resource rich, the most evolutionarily favorable strategy is to voraciously consume those resources rapidly. This has two benefits. First, it makes those resources available to an individual for making offspring. Second, it removes those resources from the pool, keeping them away from equally hungry competitors.

Biology has shown time and time again that this approach has consequences. In almost every species studied that I know of, permitting organisms to eat as much as they want shortens their lifespans and decreases their overall health. These animals are willing to make a sacrifice to be able to consume as much as possible and have the best chance of leaving the population with abundant offspring.

However this technique only works so long as the resources are present. When hard times come, animals convert to a different strategy, sometimes a radically different strategy. In C. elegans, for example, a relative starvation causes the worm to choose a completely different life cycle. The worm forms a 'Dauer' instead of an adult. This smaller form lives many fold longer, and waits until better times to spring into its adult form. When resources are scarce, survival beats out consumption.

And of course, humans are no exception. In good times, when resources are abundant, we are prone to consume those resources. Moreover, we are prone to turn into the voracious creature of our evolutionary history, making sacrifices for our future financial health to ensure we are not left behind in the rush. When time are hard, however, we throw a bit of a switch. We act much more cautiously, recognizing that surviving through to the next boom is our top priority. We are much more cautious with our investments, and put in the due diligence that was starkly absent in the good times.

I know I haven't really identified anything new here, but it was an idea that had never occurred to me. What does all this mean? My one conclusion would be that any large financial system, inasmuch as it tends to aggregate human perception, will be prone to the boom and bust. The deep psychological root of the human tendency (this is something that goes all the way down to worms, after all) means that it will happen again, and it there is probably little that we can do to stop it.