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Irrational Economics

Ever since I stumbled upon the book Predictably Irrational, I have been fascinated by the field of behavioral economics. I have looked for other books or articles on the subject, and found Freakonomics, Sway, and The Tipping Point, to name a few. Why did I find these interesting? It is because they seem to have the answers to the things we keep wondering about.

In my opinion, books like these show how empirical theories based on some observations and trends soon get accepted as “conventional wisdom” and we keep following them even when the underlying assumptions and facts are no longer relevant. The technology and real-estate “bubbles” are good examples of how a trend and some facts related to it soon lead to theories of  “conventional wisdom” and we feel compelled to follow them. During the stock market boom, it was not uncommon to see people use money from credit card or other loans to invest heavily in stocks. The belief was that using someone else’s money for your investment  was  a smart thing to do. “If you have spare money, invest in real estate, because that can only go up” was another gem from conventional wisdom.

In the midst of all the frenzied activity of the booms, I am sure many of us wondered how some of the things could be sustained over time. The web may accomodate an infinite number of  Amazons, cars.coms, and hotels.coms, but they are catering to only a finite number of people who are going to buy from them. How can the number of jobs keep increasing for ever? How can people keep buying costlier and costier homes? Where does the money come from? Doesn’t it mean that everyone is using money that doesn’t exist in the form of loans and mortgages? Aren’t recessions inevitable?

Unable to find a rational explanation to such questions, I tried to convince myself that, being an engineer, with my simplistic thinking, I would never be able to grasp the complex economic theories that kept the world going. For sure, so many smart investors couldn’t be wrong. After all, they do this for a living, unlike me who just wonders for a few minutes about these things, between writing programs. I would tell myself that one day, I would take a course or read some books to understand how the wonderful engine of economics works.

And suddenly, it is very clear why it could never work  forever.

I just read a post in Prof. Dan Ariely’s blog: How the crash is reshaping economics, that quotes an article from The Atlantic. That is what really prompted me to write this post today. What the article says is that a lot of the economics theories that are being used today haven’t advanced at all in the past 80 years or so. While some of these could have been very relevant in 1920s and 1930s, they are probably completely out of place in today’s context. It makes me shudder to think that the economists have followed these theories like a “faith” and not like a “science.” Scientific theories are constantly reevaluated; some are discarded and some new ones are formed. But a faith is a faith; you don’t question it.

It is disheartening that the economic experts could not or would not see the disaster that was coming and take some corrective steps in time.  Did they just not know it was coming? Did they just keep wondering about it just like us lay people and did not want to admit it? Or was it the “faith” that these are time-tested theories and everything will turn out okay that made them complacent?

Whatever the reasons are, I think what behavioral economics tells us will shape a lot of things in the future, as you can see here. 🙂

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