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peep from him about his successful investment. Then one day, the fol-
lowing note arrived with the subject line of “a little bragging.” It read, “I
was pushing Nortel big back at around $1. Well Nortel is over $8 today;
up $1. Call me Warren :-)”
After months of watching Nortel stock climb, Doug™s lizard brain
made him send this e-mail at this particular moment. A Wall Street clich©
is that “nobody rings a bell when it™s time to sell,” but this bragging
e-mail was a perfect time to sell. Within a short period after the e-mail,
Nortel™s stock returned to $3, going down even faster than it had risen.
The message is that unfettered emotions are not the investor™s friend.
Doug™s decision to buy was driven by analysis in his prefrontal cortex,
his decision to gloat, by his lizard brain.
A recent study documented the physiological reaction that people
60 The New Science of Irrationality

have to market information. Professor Andrew Lo and Dmitry Repin
wired up a group of professional traders.24 With a setup not too different
from a heart stress test, these MIT researchers were able to measure
minute changes in body temperature, skin conductance, and a host of
other variables. The traders they wired were trading real money for an
investment firm.
What happened to our wired traders when news broke? Lo and Repin
report two interesting findings. First, all the traders”even the most
experienced”had measurable emotional responses to news. Second, the
more experienced traders had weaker emotional responses than their
less-experienced colleagues.
These physiological responses may help us understand mean markets.
When people see stock price changes or read about world events, we
have physiological responses. If we act on those emotions, we tend to
make precisely the wrong moves. In other words, we need to shackle the
lizard brain in order to make money.
To be successful we have to damp down our emotional response
(toward the lower response of the experienced professional traders in the
MIT study) or we need to prevent our emotional reactions from impover-
ishing us. The “timeless tips” of Chapter 10 focus on ways to shackle the
impulsive and unprofitable lizard brain trader who lurks inside us.

A Guide for Bubble Hunting

As the title would suggest, the Incredible Shrinking Man portrays the life
of a person as he goes from normal size to tiny. As the protagonist con-
tinues to shrink he faces danger from a house cat and”when even
smaller”from a spider. Eventually our hero realizes he cannot cower
indefinitely. He confronts the spider, and even though the beast is much
larger than the shrunken man, he kills it with a pin. After this victory, the
movie ends as our hero prepares to leave his former house with a cocky
walk and a blood-covered weapon slung over his shoulder.
Crazy World 61

Similarly, we reach the end of the first section of this book and push
off into a dangerous and unknown future. The science of irrationality has
proven that people make a variety of errors. Furthermore, markets do not
always iron out those errors and people sometimes stampede into and
out of markets at precisely the wrong time. Markets can indeed be mean,
but because markets can be crazy, opportunities exist for profitable
While markets are irrational, the profits are hard to obtain precisely
because $100 bills persist in the lizard brain™s financial blind spots. Just
as we must use a mirror and other tricks to see into the blind spots on our
cars, we need help to spot market opportunity. We have one tool so far
and that is sentiment. We know that in order to make money, we must
make the unpopular moves and attempt to constrain the lizard brain.

Old Art
64 The Old Art of Macroeconomics

e ended Part One with the conclusion that both individuals and
markets are far from rational. Thus, the answer to the Mean
Markets and Lizard Brains question of, “Where should I invest
my money?” varies depending on the circumstances. Sometimes the con-
ventional wisdom of stocks will be correct, but sometimes other invest-
ments will be better bets.
Part Two sets the macroeconomic stage for choosing investments.
Because markets can be far from rational, we cannot assume that prices
are fair. Rather, we need to evaluate the prospects for bonds, stocks, and
real estate. This section analyzes the fundamental forces that drive
investment returns.
Chapter 4 presents an economic snapshot of the United States. Will
government deficits hurt the economy? Can the productivity revolution
allow us to be richer and lead better lives? Chapter 5 examines the
prospects for inflation and deflation. Is the Federal Reserve creating
inflation? Why would anyone worry about prices being too low? Chapter
6 looks at the U.S. trade deficit and its implications for the value of the
U.S. dollar. How will the decline in the U.S. dollar affect investors?
When will the dollar decline end?
chapter four

America the Talented Debtor

Financial Hangover versus the American Spirit

“It was the best of times, it was the worst of times.” So wrote Dickens in
his famous opening to A Tale of Two Cities. Dickens continues with, “it
was the age of wisdom, it was the age of foolishness, . . . it was the sea-
son of Light, it was the season of Darkness, it was the spring of hope, it
was the winter of despair.”
Dickens intended that this description be applicable to all times. And,
not surprisingly, his sentiments provide a good summary of modern
times, both generally and economically. In this chapter we examine com-
peting arguments regarding the U.S. economy. In one camp are the
worst-of-timers”the doom and gloomers who predict a financial hang-
over that will last for years or decades. On the other side are the best-of-
timers”the bright-eyed new-agers who predict a magical world filled
with material abundance and leisure.

66 The Old Art of Macroeconomics

Revolution lurks just offstage throughout A Tale of Two Cities. The
story begins in 1775, and Dickens™ readers knew that by the end of the
century the streets of Paris would run red from the reign of terror. Rev-
olution also lies at the heart of the debate about the modern economy.
While the current revolution is less bloody than that experienced in
eighteenth-century France, it is no less fundamental.
The Industrial Revolution loosened the connection between physical
labor and economic wealth. With machines we no longer needed to work
like animals. Even with machines, however, we still needed to work.
Now the information technology revolution promises material luxury
without work.
Even though he had never seen a computer, the famous economist
John Maynard Keynes summarized the optimistic view in his 1930 essay,
“The Economic Possibilities for Our Grandchildren.”1 In it Keynes looks
forward to a materially rich world filled with leisure. He imagines that
his grandchildren will have so much abundance they will work very few
hours and spend the rest of their time on artistic and intellectual pursuits.
In fact, Keynes worries about the lack of work to fill the day:

we shall endeavor to spread the bread thin on the butter”to make
what work there is still to be done to be as widely shared as possi-
ble. Three-hour shifts or a fifteen-hour week may put off the prob-
lem [of too little work] for a great while. For three hours a day is
quite enough.

If such a world is to exist for our grandchildren, information technol-
ogy seems destined to play a major role.
Published in 1859, A Tale of Two Cities contained a cautionary tale. It
warned that those who do not prepare for change well might end up at the
wrong end of a guillotine. Specifically, Britain had to be careful to avoid
the bloody aspects of change that befell (and beheaded) French society.
Similarly, the specter of the Japanese economy hangs over the United
States. In the late 1980s, the Japanese economy was surging and analysts
U.S. Economic Snapshot 67

confidently predicted future greatness. Over the last 15 years, the Japa-
nese economy has stagnated, unemployment has risen dramatically, and
confidence has waned. Japan still leads in many economic categories,
but also has a suicide rate that is among the highest for industrialized
So what path will the United States follow? Will it be Keynes™ vision
of examined leisure created by information technology, or will we stum-
ble down a painful path similar to that taken by post-bubble Japan?
We will develop the answer to this question throughout this chapter.
To understand the problem we will have to wade knee-deep in economic
statistics of debts, deficits, and productivity. When I ponder the U.S.
economy, however, I do not think only of economic data. In addition, I
think often of a high school classmate of mine”Steve”and his behavior
in the fall of 1975.
In 1975 I was a junior in high school on a mediocre cross-country run-
ning team. Actually both the team and I were mediocre”so bad that our
archrivals and state champions, Grosse Pointe North, used our competi-
tions as practice days. Rather than drive to our competitions, “North”
would run eight miles just to get to the starting line. They™d then run the
three-mile race, defeat us handily, and run the eight miles back home.
They didn™t want to waste a training day by running just a few miles
against such a pathetic team as ours.
Into this gloom came the “new guy,” Steve, a young man with a great
natural talent for running. Although he had not been on the team in pre-
vious years, he showed early promise and soon became the best runner
on our team.
The funny thing about Steve, however, was that he didn™t sacrifice
much to be a great runner. While my friend Jim and I made sure to eat
right and go to bed early, Steve was not averse to having a few drinks the
night before a competition. He would even sometimes arrive at a Satur-
day morning race hungover, his natural talent usually allowing him to
outrun the rest of us. Though on the mornings after particularly hard
evenings, we were not sure whether Steve™s talent or Steve™s hangover
68 The Old Art of Macroeconomics

would prevail. Had the excesses of the previous night been extreme
enough as to overwhelm Steve™s ability?
The U.S. economy faces a similar battle between hangover and talent.
The United States has demonstrated an unmatched ability to innovate and
produce. Our economic system seems to have a natural talent for making
products both cheaply and well. Impeding that talent, at least over the next
several years, is the financial hangover caused by the excesses of the 1990s.
What condition will win out? The hangover or the talent? To find out
we™ll delve into some macroeconomic issues. When I was an MBA stu-
dent at MIT, the economist Lester Thurow said, “If you like reading [dry]
data tables, then you should consider becoming an economist.” The shoe
that Lester described fit me perfectly; after a few years I returned to get a
Ph.D. and became an economist.
When I tell people at social functions that I am an economics profes-
sor, a very common response is “that was my worst course in college.” I
have met literally dozens of people who took one economics course,
found it distasteful, and stopped. Part of this dislike of economics comes
from the standard teaching style (boring!), but part is due to the very
nature of the subject (including dry data tables). As hard as it is for me to
understand, I have learned that some people do not enjoy reading eco-
nomic statistics.
Furthermore, some people can succeed financially without studying
economic numbers. Take my friend David who works as an oil trader in
the New York Mercantile exchange. He does his trading in a crowd on the
floor of exchange”just like the people shown screaming at each other on
TV and in movies, David makes his living by buying and selling oil. In
fact, David once joked that his epitaph ought to read, “He yelled for cash.”
David™s yelling has resulted in quite a bit of cash. His lifetime earnings
are north of $10 million, and he has earned more than $1 million in some
How does David make his money?
In the early days of trying to figure out David™s secret, I used to grill
him. “Do you think that the United States will start constructing new
nuclear power plants and thereby reduce demand for oil? How did the
U.S. Economic Snapshot 69

1991 oil fires set by Saddam Hussein™s troops affect the future capacity
of Kuwaiti production?” To all of these questions, David would calmly
answer, “I do not know.” He even joked that to make money he wouldn™t
even need to know the number of gallons in a barrel of oil (42).
What is David™s secret? He summarizes it by saying, “I know when the
buying is real and the selling is real.” David stands in the crowd, listens,
observes, and acts. He capitalizes on emotional signals from his counter-
parts, and he uses little or no formal economic analysis.
So is it possible to make money just by exploiting knowledge of senti-
ment, with no economic analysis? The answer is yes, but I believe it is
possible to make even more money by combining economic analysis with
the science of irrationality. That is the course that we will follow in the rest
of this book, and it requires that we delve into the economic details.
We begin with the economic evidence in favor of the worst of times,
and then move to the arguments in favor of the best of times.

Bear #1: Animal House Fraternity Goes National

“Fat, drunk, and stupid is no way to go through life, son,” says Dean Ver-
non Wormer on his way to expelling the members of the Animal House
fraternity. When learning of his expulsion, John Belushi™s character
Bluto remarks, “Seven years of college down the drain!”
The first argument against the U.S. economy suggests that an eco-


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