Neuroeconomics: sub-prime mortgages exploit a bug in our brains

At The Frontal Cortex science blog, a fascinating explanation of the neurology of subprime mortgages. FMRI research shows that long-term decision-making takes place in a different part of the brain from short-term decisions — so when you offer someone a cheap two-year mortgage followed by 28 years of scorchingly high interest rates, the short-term side jumps in and overrides the sober long-term mind.

This discovery has important implications. (A more recent paper by the Cohen lab extends the theory.) For starters, it locates the neural source for many of our financial errors. When we opt for a 2/28 mortgage, we are acting like experimental subjects choosing the wrong gift certificate. Because the emotional parts of our brain reliably undervalue the future – life is short and they want pleasure now – we end up delaying saving until tomorrow (and tomorrow and tomorrow.) George Loewenstein, a neuroeconomist at Carnegie Mellon University and a collaborator on the Cohen paper, thinks that understanding how we make decisions will help economists develop better public policies: "Our emotions are like programs that evolved to solve important and recurring problems in our distant past," he says. "They are not always well suited to the decisions we make in modern life. It's important to know how our emotions lead us astray so that we can design incentives and programs to help compensate for our irrational biases."