NARRATOR: Does raw human emotion dictate your financial decisions?

I like to shop.

I love shopping so much.

NARRATOR: Or are we rational calculators of our own self-interest?

If you believe that, you can believe that pigs will fly.

NARRATOR: It' that has real-world consequences.

TV REPORTER: Let' with which we are watching this market... NARRATOR: The crash of 2008 nearly collapses the global economy.

TV REPORTER: A trillion dollars in mortgage investments have gone bad.

WOMAN: The crash really matters.

It is unexplained by the discipline of economics.

MAN: That' a pointless insult.

NARRATOR: A set of amazing experiments reveals it was no surprise.

MAN: It was driven by psychology.

NARRATOR: Experiments show our behavior is bizarre when it comes to money.

MAN: It' irresistible force.

NARRATOR: But not everyone agrees.

MAN: The observation that people feel emotions means nothing.

The opening...

I won' NARRATOR: What happens when two powerful forces collide?

MAN: Emotion still drives the markets.

NARRATOR: "Mind Over Money," right now on NOVA.

Major funding for NOVA is provided by the MAN: Okay, who' NARRATOR: It' that challenges all our ideas about money.

Okay, who wants to bid?

NARRATOR: An auction of a $20 bill.

One dollar.

Do I hear two dollars?

Who' two dollars.

Do I hear three?

Three at the back.

How about four?

How about five?

Anyone five?

Five.

Six?

Seven?

NARRATOR: The rules are simple.

The highest bidder will get the $20 bill.

Eleven?

Eleven.

NARRATOR: But there's a catch.

The second highest bidder receives nothing but pays the amount of the losing bid.

Do I hear 20?

Twenty.

20 dollars.

(laughter) NARRATOR: Amazingly, two participants bid way above the face value.

Twenty-six.

Twenty-seven.

27 going once... Twenty-eight.

Twenty-eight.

How about 29?

28 going once... NARRATOR: So why would anyone pay more than $20 for a $20 bill?

$20 sold for $28 to this gentleman.

What a deal.

NARRATOR: A group of scientists called behavioral economists think they have the answer.

It just popped, and now he starts again.

NARRATOR: They believe that when it comes to making decisions about money, the human mind often behaves irrationally.

JENNIFER LERNER: We see a variety of ways in which people depart from rationality.

People are not using the information they say they should be using, and instead they' other information that they told us one would be crazy to use.

WOMAN: I' your skin temperature.

NARRATOR: The notion that people can behave irrationally when it comes to money may not seem like a radical idea.

But it challenges the dominant economic philosophy that has shaped policy in business and government for the last five decades.

The intellectual heart of this philosophy is here at the University of Chicago.

This campus has given rise to more Nobel Prize winners in economics than any other institution in the world.

Nearly all of them share a common assumption-- that when it comes to money, people are highly rational.

One of the great champions of this view is Gary Becker.

BECKER: The most powerful theory we have, and I think it' powerful theory in the social sciences, is economics as a theory of rational behavior individual level, and that' we rely on.

So what is economics?

NARRATOR: University of Chicago professor John Cochrane is another leading proponent of this rational model of economics.

And how do we do it?

We start by thinking about people and by thinking about how people behave.

People' What do they want?

How do they go about getting it?

NARRATOR: It' 200 years ago by the father of economics, Adam Smith, in his book Wealth of Nations.

COCHRANE: He started economics in a way that Newton and Galileo started physics.

He defined our field in some sense and came across some of the basic insights that people working in their self-interest could coordinate in markets and produce wonderful outcomes.

NARRATOR: So what did Adam Smith mean by rational and self-interested behavior?

Take an average person in today's world.

He' to increase his wealth.

BECKER: Adam Smith basically said people are rational, selfish even, so a very narrow form of rationality.

NARRATOR: Before he makes a purchase, he works out exactly what things are worth to him, be it a cab ride or buying stocks.

His goal is never to pay a cent more than he must.

And while he has emotions, they never sway him from his own financial self-interest.

For Smith, individuals behaving rationally are an invisible hand that keeps the whole economy stable.

BECKER: He put it all together and he ended up with results that are very modern.

I mean, you know, economists over the years have modified it a bit, but Adam Smith really had the basic insight.

COCHRANE: We put those behaviors together... NARRATOR: Two centuries later, economics has evolved into a rigorous discipline.

Having understood behavior, having thought about the markets, where people interact with each other, we understand the predictions of that model for the facts.

NARRATOR: And Smith' into how rational people make financial decisions are now expressed in precise mathematical equations.

JUSTIN FOX: Starting after World War II, increasingly in economics you had to say it mathematically if you were going to be taken seriously.

Economics from the very beginning had been pretty much the study of rational, greedy people making decisions to try to enrich themselves.

And it turns out you can come up with some pretty elegant ways of expressing that mathematically.

NARRATOR: Today these mathematical models are the main tools used by economists to shape policies that affect us all... from the interest rates set by the government and the level of taxes to how much we can borrow from banks.

Behavioral critics of these models believe they take Adam Smith' insights to an extreme.

They represent people as doing immense calculations with immense databases.

NARRATOR: The main model of consumer behavior assumes that we never buy anything until we' the impact on, for example, our retirement fund.

And we' we use interest rates to compute our pleasure over time after buying something.

SHILLER (laughing): What are you talking about?

What interest rate do I have in my head?

That' that the models require that everyone is consistent about.

NARRATOR: Rational economists concede that people don' these calculations.

But they have a well-known defense: "As If."

The way economics textbooks are written, they don' this way, they say people behave as if they were doing this.

COCHRANE: And when we do that, we' assuming that the people in the real world actually make those calculations; we' they behave as if they do.

NARRATOR: Behavioral economists like Richard Thaler are unconvinced.

THALER: Defending economic theory, economists made a point about expert billiards players, that they might not know anything about physics or trigonometry, but they play as if they do.

Now, that' Let' like this.

I might be able to make this shot.

And an expert would make it, I can make it too, but let' Let' this ball in this pocket.

Now, I know the trigonometry, I got to get the angles right and so forth.

An expert would have no problem with it, but for me, this is a pretty hard shot.

Ooh!

Close!

Most of the time, we' expert billiards players.

When people face hard problems, they make mistakes.

NARRATOR: At the center of all the rational models lies an unflinching belief in free markets.

The idea is to keep regulation and government interference to a minimum, in both the everyday consumer market and in the giant money markets of Wall Street.

Rational economists believe that the increase in wealth worldwide over the last 30 years is a triumph for free markets.

BECKER: It lifted maybe a billion people out of real poverty, and I mean real poverty-- they had one dollar a day or two dollars a day.

That' And it lifted those people above those limits.

TV REPORTER: What in the world is happening on Wall Street?

NARRATOR: Then comes the crash of 2008.

TV REPORTER: Veterans traders says they' never seen anything like it.

NARRATOR: The stock market drops over 40%.

TV REPORTER: The Dow traders are standing there watching in amazement, and I don't blame them.

TV REPORTER: Traders here working the phones say a lot of their customers are freaked out, waiting to see how low the Dow will go.

NARRATOR: And apparently irrational financial behavior becomes the order of the day.

TV REPORTER: Let' with which we are watching this market deteriorate.

NARRATOR: $14 trillion of wealth invested by Americans is destroyed.

TV REPORTER: This has truly been a manic Monday on Wall Street.

NARRATOR: Fear grips the markets... TV REPORTER: The stock market suffered one of its worst days in years.

NARRATOR: And financial experts are forced to imagine the once impossible... MAN: We haven' anything like this since the Great Depression.

NARRATOR: The global economy coming to a halt.

LEO MELAMED: I shudder to think if all of that stopped.

The consequences are beyond imagination.

There would be hunger.

There would be war.

There would be strife.

There would be total unemployment.

We' on the banks.

It would put the world back a hundred years, maybe more.

NARRATOR: The chaos seems to undermine decades of economic thinking.

BECKER: Economists as a whole didn' So that' on economics and it' for markets.

TV REPORTER: This market took five years to go higher.

It' NARRATOR: With the crash, the rift in economics widens between the rationalists and the behavioralists.

TV REPORTER: We are talking about financial Armageddon.

LERNER: The crash really matters because much of the behavior that led up to the crash is unexplained by the discipline of economics.

I' an empty argument.

That's just an insult, a pointless insult.

We don' of economics, but we need a whipping boy, and economists have always kind of been whipping boys.

So they' it' NARRATOR: So which side is right?

Are we rational about money or do our emotions and psychology play a much bigger role than previously realized?

Okay, everyone, we' to start off with a game.

NARRATOR: Take the auction of the $20 bill that sold for $28.

One dollar?

WOMAN: One.

One dollar.

How about two?

Two.

Two.

NARRATOR: In the rational model, a person should never pay $28 for a $20 bill.

Five in the back, how about six?

NARRATOR: Paying more than something is worth cannot be in anyone' financial interest.

The auction is a key experiment for behavioral economists.

THALER: It' and it' if you don' than a couple steps ahead, you fall into.

Eleven?

Eleven.

Twelve.

NARRATOR: It' to win that drives bids up... Fourteen.

Do I hear 20?

NARRATOR: And the fear of being the loser that drives them even higher.

Twenty-three.

Twenty-four.

Twenty-five.

THALER: And now it's a game of chicken.

Twenty-seven.

27 going once.

Twenty-eight.

Twenty-eight!

$20 sold for $28 to this gentleman!

What a deal.

And you owe me $27 as well.

Nobody will want to play that game twice.

NARRATOR: The auction may seem far removed from everyday life.

But do people outside of the classroom behave just as irrationally?

We asked shoppers in a Chicago mall if they would prefer $100 in a year' or $102 in a year and a day.

I' in a year and one day.

102 dollars.

Year plus a day.

I mean, I can wait that extra day for it, the $102.

It really wouldn' any difference.

I would do the 102 a year and a day from today.

NARRATOR: They all made the rational decision... What' year of waiting?

NARRATOR: And chose the bigger amount.

Then they were asked if they would prefer $100 today or $102 tomorrow.

The larger amount is still the rational choice.

So what did they say?

I' right now.

I would take $100 today.

I would prefer the $100 today.

Today.

I would take $100 today.

NARRATOR: The desire for a quick reward... $100 today.

NARRATOR: Trumps their rational self-interest.

There's something called present bias-- that if we have the option of something right now, it' NARRATOR: According to behavioral economists, this bias may explain why we save less than we should.

Are there other psychological forces that impact our decisions.

A bottle of wine.

NARRATOR: In this experiment, students are asked to bid for a bottle of wine.

Rational economics suggests they will carefully calculate what it' But before the bidding begins, they' the last two digits of their Social Security number on their bid sheet.

Astonishingly, the people who bid the highest for the wine were those who had the highest Social Security numbers.

Unwittingly they' influenced by a completely irrelevant number.

THALER: It is a great illustration of anchoring.

People are anchored on some number they were given, even when they constructed it at random like the last two digits of their Social Security number.

It's an almost irresistible force.

NARRATOR: Do experiments like these expose flaws in the assumptions underlying rational economics?

BECKER: They' in the lab.

Economists are dealing with people in the real world, and there' the lab and the real world.

These experiments are very interesting and I find them interesting, too.

The next question is, to what extent does what we find in the lab translate into understanding how people behave in the real world?

And then make that transition to, does this explain market-wide phenomena?

NARRATOR: For economists like Cochrane, it doesn' if individuals sometimes go against their financial self-interest as long as most of us act rationally about money most of the time.

Nowhere is that idea more important than here-- the New York Stock Exchange, where traders buy and sell corporate stocks.

Their decisions move prices up and down, creating wealth for some investors and financial loss for others.

Richard Rosenblatt' trading here for 30 years.

All right, hang in there.

I' ROSENBLATT: When I started, our technology was electric lights and telephones and that was pretty much it.

And yet it' try to anticipate where the stock is going to move over the next few seconds or minutes and judge your trading decisions accordingly.

And if I' and I buy a stock in anticipation of other people deciding that this stock is under-priced, then I' NARRATOR: Now the stock exchange is one small cog in a vast global machine that' Technology means trading can take place anywhere.

Trading on two bucks on earnings, we' NARRATOR: At Knight Trading, one of the biggest private dealing floors in the world, traders buy and sell everything from stocks and currencies to commodities like oil and gold.

I have stuff in the opening, I won' Eight dollar-- two on the upside on eight.

Sell!

NARRATOR: And just as Adam Smith suggested, traders here compete fiercely to make as much money as possible for their clients and themselves.

JOE MAZELLA: You want to win, and it' competitive nature of all of us that drives us to push harder and harder each day.

if I' and I' and I see somebody next to me who' it gets me going.

That' Hey, Tommy?

The 38,000 guy added 50, so... Two XM for a buyer.

23.90 for 100.

NARRATOR: And why does it matter what happens in places like this?

Most of us use financial products like mortgages or mutual funds.

The firms that sell us these products take our money and invest it to make more money in the financial markets.

If traders make profits for these financial firms, they can then offer us cheaper mortgages and better mutual fund returns.

The result: a matrix of money that connects us all.

It' that says most of the time, most of us and most of the traders behave rationally.

But what if this model of human behavior isn't right?

TV REPORTER: Stocks shot higher, giving the Dow its best day in almost two years.

NARRATOR: In 2005, rational economics, it seems, has delivered.

Times are good and have been for years.

JIM LEHRER: There' market in many parts of the country right now.

NARRATOR: Many people think the long boom will continue.

GEORGE BUSH: Our economic horizon is as bright as it' in a long time.

TV REPORTER: For those in the housing business, these are gold rush days.

NARRATOR: Economist Robert Shiller is unconvinced.

SHILLER: It did seem to me that there was complacency and an overriding feeling of normalcy, that this can' NARRATOR: He thinks the boom is a mirage.

TV REPORTER: While the real estate market has grown to new heights and new prices never seen before.

NARRATOR: He' in particular-- housing.

Housing prices have gone up six percent a year for decades.

In 2005 in some places they're rising at 25%.

This was very anomalous performance.

The idea that home prices always go up led people to think that they had all found the investment to end all investments.

TV REPORTER: Thousands came to a two-day expo hoping to learn how they could turn investments in real estate into personal riches.

NARRATOR: Shiller believes America is in the grip of an irrational mania... TV REPORTER: July was still the strongest housing sales month in history.

SHILLER: I predicted that it was likely to correct down and that it might cause a huge financial crisis and a worldwide recession.

NARRATOR: In a book tour that summer, he warns of the dangers.

RADIO ANNOUNCER: Economist Robert Shiller is out with a new book titled Irrational Exuberance.

It' that we get into when prices keep going up and we see a lot of excitement.

That' NARRATOR: Rational economists dismiss his warnings.

COCHRANE: What does irrational exuberance mean?

It' a view that prices are higher than Bob Shiller thinks they ought to be.

Bob, who' has been consistently pessimistic about-about prices.

NARRATOR: The debate about whether rising house prices are the result of a mania or rational calculation intensifies.

BECKER: The individual household was not being irrational.

They were getting low down payments, low interest rates, so it was a rational decision to make, particularly when they expected prices to continue to rise over time.

NARRATOR: Financial institutions share the conviction that house prices will continue to rise.

They offer mortgage deals never seen before.

And the country's top financial officials are optimistic.

ALAN GREENSPAN: The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices.

House prices have risen by nearly 25 percent over the past two years, and at national level, these price increases largely reflect strong economic fundamentals.

NARRATOR: This confidence isn' just a shared hunch.

It' accepted models of rational economics.

FOX: Basically you build the models assuming people were like these calculators who would look at the range of possible outcomes and the risks and balance it all out.

NARRATOR: In 2005 the economic models assume consumers will make careful calculations about their mortgages.

THALER: Economists assume we shouldn' about people taking out 95% mortgages or 100% mortgages or "trust me" mortgages, because they' those mortgages if they have made all of the relevant calculations.

(cheering) NARRATOR: Instead, as housing prices soar, many consumers take out mortgages they cannot afford and assume debt based on the rising value of their homes.

So why might so many people be willing to take on so much risk?

At Stanford University, researchers stumble on a possible answer.

Their research at first has nothing to with money.

It isn't even being conducted by economists.

Psychologists are using powerful brain scanners to explore the mysteries of the human mind, especially emotion.

BRIAN KNUTSON: I started looking in the brain because I was interested in emotion and I was convinced there must be something in there that could give us a handle on emotion.

NARRATOR: Psychologist Brian Knutson wants to know how emotions affect one of the oldest parts of our brain, that evolved so long ago we share it with many creatures, even lizards.

In general, the lower the area of the brain, the farther back it goes in evolution, right?

So we humans still have these sub-cortical areas deep in the brain that are ancient.

NARRATOR: This part of the brain is called the nucleus accumbens.

And it gets triggered by the most primal human needs.

KNUTSON: From the standpoint of survival, it makes a lot of sense that natural rewards, like food and sex and so forth, would activate this circuit that makes you go out and get those rewards.

NARRATOR: This part of the brain plays a crucial role in drug addiction.

Out of curiosity, Knutson tries to find things that excite it as much as the prospect of sex and drugs.

So he asks people to imagine they are about to receive some money.

KNUTSON: Once we started using money, we found very reliable activation in these emotional circuits.

This suggests that it' not just sex, it' it' activates these circuits; money also activates these circuits, and it does so very powerfully.

NARRATOR: Could the fact that an ancient part of our brain gets excited by money explain some of the frenzied behavior by financial traders and consumers during the housing boom?

Rising house prices are an example of a phenomenon called a speculative bubble-- when prices of a financial asset suddenly take off and keep rising.

Robert Shiller believes it' that drives them.

SHILLER: What' that as the bubble grows, more and more people are coming in and they' envy for the other people who are shamelessly boasting, "I made more money than you did all last year working."

And for a while, you think, "It can' But then you think, "Maybe I was wrong.

Maybe I should get into this."

And it' by human emotion.

NARRATOR: This link with emotions makes many rationalist economists reject the idea of bubbles.

FAMA: I used to think I knew what the word "bubble" meant, but I don't think I know what it means anymore.

I cancelled my subscription to The Economist because the word "bubble" appears three times in every page there now.

I think it' totally gratuitous.

It' NARRATOR: Bubbles sound innocuous, but financial journalist Justin Fox has studied their history and discovered what happens when they burst.

The first financial bubble involved something highly unlikely.

FOX: In the 1630s in the Netherlands, people were buying and selling tulip bulbs.

Complete, mass insanity in Holland for a couple of years there, where hundreds of people, artisans, would leave their workshops and set up business as florists, they called themselves, even though for the most part what they really were were tulip bulb traders.

And it was a real financial market.

SHILLER: The price of tulips in Holland rose to such a level that the value of one tulip bulb would sometimes be the same as that of an entire house.

NARRATOR: Over a three-year period, the price of tulip bulbs rose and rose and then began to soar.

By some accounts, almost half of all the money in the Dutch economy was caught up in trades involving tulips.

To a lot of historians, this is really the first example of a financial bubble, even though it was basically tulips.

People were buying them not primarily because they liked tulips, but they were buying them because they thought that the price was going up and they could resell them to someone else at a higher price.

NARRATOR: On February 5, 1637, the most expensive bulb in Holland failed to sell and tulip investors panicked.

SHILLER: Then it burst as prices start falling.

And then they' and then you start thinking, "You know, I remember I doubted "that tulips could possibly be worth so much.

Maybe I better get out fast."

And then everyone starts dumping and then it just drops.

NARRATOR: As the prices plunged, leading citizens found themselves bankrupt.

Some historians estimate it took a generation for the Dutch economy to recover.

There have been many bubbles and crashes since.

But the most famous happened closer to home.

(festive ' The year 1929 began with optimism.

Stock prices had been rising for eight years.

And in ' FOX: The 1920s was a great decade economically.

The economy was booming, industry was booming, and toward the latter part of the decade, financial markets just sort of went from reflecting that boom to kind of creating it.

It was just boom times all over.

By the late 1920s, there was just this feeling new era.

NARRATOR: Observers described feverish emotions as thousands of investors paid ever-higher prices for stocks.

In the so-called "roaring ' the stock market went through an enormous bubble.

People thought it would never end.

NARRATOR: But then, on October 29, prices suddenly dropped, and the mood turned to one of panic and fear.

Over 9,000 American banks failed, wiping out the life savings of millions.

SHILLER: It led to a depression that lasted over ten years.

BECKER: We had 25% unemployment for most of the decade of the 1930s.

SHILLER: It was an event that was driven by a real change in people' that led them to be very optimistic and positive in the ' and then negative in the ' NARRATOR: This view that emotions can drive an economy up or down became the conventional wisdom of the 1930s, through the work of the renowned British economist John Maynard Keynes.

There' rise in the cost of living.

FOX: Keynes believed financial markets arrived at prices in a pretty crazy fashion.

His classic quote is that the market can stay irrational longer than you can stay solvent.

NARRATOR: Keynes said emotions could cause prices to soar and then collapse.

And to protect the economy from these dangerous bubbles, the markets had to be firmly regulated by government.

Keynes, though, could never explain exactly what the mechanism was.

SHILLER: Keynes never got past the fuzzy stage.

And it didn' to a precise mathematical model.

And that' Keynes was rejected by the profession.

NARRATOR: Now, after the crash of 2008, behavioral economists are struggling to do what Keynes could not: show precisely how human emotions affect prices.

Their ideas are so influential that behavioral experiments are now conducted even at the University of Chicago, the citadel of rational economics.

One explores a mysterious psychological bias.

We are interested in how much you would pay for this mug or one identical to it.

NARRATOR: These students have been told to work out the price of a common consumer item.

A travel mug in beautiful maroon.

NARRATOR: They' would be prepared to pay to buy the mug.

Write down the maximum amount you' for this mug or one identical to it.

NARRATOR: They offer an average of six dollars.

So we now have six of these mugs.

We' to raffle them off by selecting a few people at random.

NARRATOR: And then they' the same mug for nothing.

An hour later, they' be willing to sell it for.

In rational economics, the price should be exactly the same.

After all, the value hasn't changed.

But the average price they want for the mug now is nine dollars.

MAN: When you wanted to sell the mug back once you had it, you gave a higher price.

It just made it seem a little bit more special because it was going to be something useful to me.

Anybody else?

Well, I got this mug by complete luck and so it' and I have to charge this much for it.

NARRATOR: The emotional pleasure of owning something for just an hour pushed the price up by 50%.

It' suggesting we are unaware of the emotions that drive this behavior.

At Harvard, researchers are exploring the financial impact of these subtle influences.

The team is led by Jennifer Lerner.

LERNER: I' not a clinical psychologist.

I don' therapy, et cetera.

I do experiments in a laboratory.

I come with the assumption that much of what' in terms of influencing a decision is outside of conscious awareness.

NARRATOR: Lerner explores all sorts of emotions.

Today it' impacts financial decisions.

WOMAN: We' by placing these two sensors.

They measure skin conductance, or sweating response.

NARRATOR: The experiment is designed to induce emotions at such a low level the subjects aren't aware of them.

So the researchers use sensors to track the physiological effects of the emotion...

So now we' to get ready to collect the first saliva sample.

NARRATOR: From heart and breathing rate, to the hormones in saliva.

LERNER: These are physiological signals from the subjects.

When we have them first come in, they sit and have a period of quiet rest, relaxing to music, that sort of thing, so that we can see what they' And then we use that to compare what happens when they might be in the midst of a stressful financial decision.

NARRATOR: Among other activities, the subjects watch a scene from a sad movie.

Unbeknownst to them, this triggers low-level sadness.

Their sensors reveal the emotional change.

LERNER: The decision makers in our studies are completely unaware that the sadness is impacting them.

And when we ask them, did the film you saw change your responses in any way, they say no.

NARRATOR: It's time for the financial test.

The subjects are directed to make a series of financial choices.

Then, they are asked how much they would pay for a consumer product-- in this case, a water bottle.

Lerner compares their choices to those of a group not shown the sad video.

LERNER: Here is an example of a subject in the neutral condition and this subject is telling us that they would like to buy it at $2.50.

And that contrasts with here, we have data from a subject who' and this subject is willing to pay ten dollars to obtain the water bottle.

And that is very representative of what we see.

You get this increased valuation when you' NARRATOR: If sadness can lead people to pay four times more for a water bottle, what happens when the stakes are higher?

The experiments have been done with high-stakes money, thousand dollars, et cetera, and what we find is that these results scale up, even when you use big money.

NARRATOR: If emotions influence prices on the individual level... what about markets and the larger economy?

According to rational economics, these are driven by individual self-interest.

But for Robert Shiller, this ignores something obvious.

SHILLER: Humans are empathetic animals.

Uniquely empathetic.

We' ideas, we' That' It' It' the same thing.

I know what you' because it' the same feeling that you have.

JIM LEHRER: There' market in many parts... NARRATOR: If Shiller is right, could empathy explain how the hyper-optimism of the housing market jumped like a social contagion to the financial markets?

TV REPORTER: While the real estate market has grown to new heights... NARRATOR: Among professional traders, the idea that moods flow through markets is taken for granted.

DAN MATHIESON: The market is an aggregation of what thousands of people think the future is going to be like, and if these people are optimistic about the future, the market goes up, and if people are pessimistic about the future, the market goes down.

But at the end of the day, the question the market answers is, are people optimistic or are they pessimistic?

And that' question.

Emotion still drives the markets.

TV REPORTER: They' will not burst... NARRATOR: For rationalists, emotions are not a satisfactory explanation for how markets work.

COCHRANE: The observation that people feel emotions means nothing.

And if you' to just say, oh, markets went up because there was a wave of emotion, you got nothing.

That doesn' about what circumstances are likely to make markets go up or down.

That would not be a scientific theory.

NARRATOR: The rationalists' is based on the mathematical model they use to understand the financial markets.

It's called the efficient markets hypothesis, and it says that financial markets act essentially like a giant calculating machine, efficiently processing all relevant information faster than any individual could.

So if some traders are emotional, it doesn't matter.

FAMA: Efficient markets can exist side by side with irrational behavior as long as there' rational people to bring prices in line.

NARRATOR: In the efficient markets model, the financial markets themselves are rational and prices at any moment in time cannot be wrong.

It was a model invented by Eugene Fama.

FAMA: It's a pretty good model.

For almost every practical use you would put that model to, it works pretty well.

It created a big fuss.

And the fuss persists to this day.

NARRATOR: The fuss persists because for many behavioralists, the theory implies financial markets should be immune from criticism or control.

SHILLER: The theory is that we have to look at markets as oracles.

When the market moves up, we have to say, "What is the wisdom of the market telling us today?"

THALER: If markets are efficient, there' for government because the market itself will make sure that prices are always equal to the right price.

NARRATOR: Instead of regulation, rationalists believe the markets will come up with their own mechanisms for managing risk.

And so they have.

The first was invented here at the Chicago Mercantile Exchange, where traders handle vast sums of money all the time.

HARRY PANKAU: I' and I trade my own money.

50 contracts to 100 contracts at a time.

That' to $100 million contract size.

NARRATOR: Traders here make their money by effectively offering to insure people against risk, including agricultural products like pork bellies and oranges.

Long before this orange became an orange, the farmer had to grow it.

Well, he doesn' be the price of that orange when it comes to the market, finally, ten months later.

Will he make a profit?

NARRATOR: As protection, farmers take out contracts to insure themselves against the price of oranges dropping.

MELAMED: Nowhere in the market are you going to see an orange passed from one trader to the next.

And yet oranges were transacted in an invisible market.

That is the risk transfer mechanism.

NARRATOR: When he was chairman of the exchange, Leo Melamed took that idea with oranges and applied it to financial assets, in a contract that became known as a derivative.

MELAMED: It was a revolutionary idea.

The board of directors looked at me as if I was half crazy.

"What do you mean?

"At the Chicago Mercantile Exchange?

"The pork belly exchange?

"You' Melamed.

You' exchange and blow it up."

NARRATOR: If you' that a financial asset like a currency might suddenly move down, you can now buy a derivative that pays you if that happens.

MELAMED: Everyone in the world uses one or another form of financial derivatives to insure the risks that they have.

NARRATOR: Derivatives are so useful, they move beyond the Mercantile Exchange and, with less oversight, take on complex new forms.

There are even some created to insure the risks of issuing millions of home mortgages.

But as all these different risks grow, someone has to measure them.

At the modern temples of finance, the atmosphere is less Chicago Mercantile and more like academia.

No wonder.

The average trader here is likely to have a graduate degree in math.

MATHIESON: The culture of trading has changed.

When I started in this business-- which wasn' in 1992-- there was a lot of screaming and yelling on the trading floors.

People were throwing phones.

Today you go out on the trading floor and it' There' of computer keys and it' of person involved in trading.

NARRATOR: These traders are called quants because they use equations and statistics to quantify their risks mathematically.

Only then do they program their computers to make trades.

The financial markets are now dominated by the highly mathematical approach of the quants, one that' to ensure risks are assessed rationally and scientifically.

There' that are an art and not a science.

What' are now a lot of aspects that are treated as a science, and that' over the last 20 years.

A quant will troll through tons and tons of data looking for patterns, and they' the numbers all day and trying to improve performance.

NARRATOR: These two key innovations-- derivatives to manage risk and mathematics to measure it-- convince many that markets are efficient, making bubbles and crashes a thing of the past.

If you believe that, you can believe that pigs will fly.

When I first heard economists coming out with that idea, I assumed that they were very badly informed, off in their ivory towers.

NARRATOR: Jeremy Grantham is a highly successful investor.

For the last 40 years, he' by spotting bubbles and betting the prices will return to normal.

We've found 27 bubbles.

NARRATOR: Grantham believes bubbles are inevitable and have a predictable rhythm.

GRANTHAM: It' to go up and realism causing it to fall back.

And then, eventually, unrealistic panic as it begins to feed on itself and the lemmings head in the opposite direction.

NARRATOR: At Chapman University in California, this cycle is studied by Vernon Smith.

SMITH: A lot of economists do not like the idea of bubbles because they' NARRATOR: In this experiment, Smith wants to see what happens when students compete to earn money on a simulated trading floor.

MAN: It's not a classroom setting.

It' in which your job is to make as much money as you can.

MAN: You will be paid based on the dividends that you have earned.

NARRATOR: If they play the game well, they could earn hundreds of dollars.

MAN: This is real money, serious money.

NARRATOR: Each of them has been given an imaginary financial asset to trade.

And right from the start they' because the asset will decline in value over time.

By the end of the game it will be worth nothing.

MAN: The asset will live exactly 15 periods of trading.

And the question is whether this will determine the prices at which they exchange or whether the prices at which they trade deviate from that.

MAN: Okay, the experiment has begun.

NARRATOR: On a screen they see the prices the other traders are offering to sell or buy at.

And they also see the value of the asset as it relentlessly declines, shown here as a dashed black line heading downwards.

As prices rise, they reach the actual value of the asset.

And something strange happens.

Everyone begins to take risks.

MAN: So you notice the price has been racing up.

NARRATOR: In the hope of making profits, they now trade high above the real value.

MAN: There' way above fundamental value.

NARRATOR: In the flurry of buying, the students are now ignoring the fact that the asset will soon be worthless.

MAN: We' and at the end of period 15, these assets are worth nothing.

NARRATOR: As the end approaches, the price remains way above the real value.

The graph has taken on a classic bubble shape.

And when the players try to get out, no one wants to buy.

Instead of earning hundreds of dollars, the students watch the graph collapse, leaving them with next to nothing.

This experiment suggests bubbles may be part of the fabric of financial markets.

SMITH: We' and with all kinds of different subjects.

I went to Chicago and I recruited some over-the-counter securities traders, put them in an experiment.

They gave us a magnificent bubble.

NARRATOR: It's a bubble, where prices go up and then suddenly plummet.

How could such a simple pattern have brought us so close to economic catastrophe?

In 2005, as housing prices grow, the mechanisms that rational economists count on to keep the markets safe become part of the problem.

Major financial institutions issue billions of dollars worth of derivatives to protect mortgage lenders against home loan defaults.

MARK WHITEHOUSE: And every time you created one, you could make six percent of the total value you created.

This was like a gold mine.

NARRATOR: These derivatives are traded and their price soars.

And suddenly they have become the 21st century equivalent of tulip bulbs.

Within a few years, $60 trillion is riding on them.

All this is fine as long as the quants are calculating risk properly.

But their mathematical model assumes the prices in markets are always correct.

WHITEHOUSE: It was assuming that house prices would keep going up.

It was assuming that very few people would default on some very risky loans.

It was essentially assuming that there was no more economic cycle.

TV REPORTER: Notice all those "for sale" signs out there on homes the owners just can' NARRATOR: When home values fall, the model breaks down.

The price of derivatives plunges, leaving financial institutions with billions of dollars of debt.

TV REPORTER: Another major financial collapse... WHITEHOUSE: Banks couldn't sell these things at any price.

So, effectively, their price was nothing.

TV REPORTER: Fears of a financial meltdown on Wall Street.

LERNER: On the eve of the crash, there was a whole intellectual edifice built on the assumptions of rational decision making.

TV REPORTER: The only bank in the red right now, Bear Stearns... FOX: It' the market is rational and perfect and knows what it' doing, when it' of freezing up and ceasing to function.

NARRATOR: As fear grips the market, financial firms pull back their money... TV REPORTER: There was blood on the floor at the end of trading.

NARRATOR: And refuse to lend to each other.

Uncertainty leads to something that looks very much like panic.

FAMA: You can give it the charged word "panic," if you' but in my view it' a change in tastes.

TV REPORTER: Half a trillion dollars in mortgage investments... COCHRANE: Emotions is how human beings make rational decisions.

You know, when that lion is coming, it' some adrenaline and some fear and that' the rational decision to run like heck in the opposite direction.

TV REPORTER: The Dow tumbled 240 points... BECKER: You take this.

If we have another 30 years like we had in the past, including this recession, this would be a great achievement for the world.

GREENSPAN: Those of us who have looked to the self-interest of lending institutions are in a state of shocked disbelief.

SHILLER: We think we' quantitative framework which takes care of all the risks, but it' It' the theory too much and they were willing to make huge bets based on a theory that really wasn' up at WGBH access.wgbh.org This NOVA program is available on DVD at shopPBS.org, or call 1-800-play-PBS.