Mind Over Money

In more layman terms, the PBS science television program NOVA, in trying to find answers to two important and related questions – one, why did main stream economists fail to predict the 2008 stock market crash, and two, why do people so often make irrational financial decisions – seeks to come up with a plausible alternative economic theory to, if not an outright antithesis of, rational economic and efficient market theory, and that is, behavioral economics.

One interesting finding of behavioral scientists interviewed in the program is that people in a fearful state of mind tend to make rise-averse choices, while people in an angry state of mind tends towards risk-seeking choices; and sadness can make spend more money. The conclusion is that anger and sadness propel people to take action, but fear makes people pessimistic and withdrawn.

Here is the link to the video (Adobe Flash Player 9 is needed to view):-

http://video.pbs.org/video/1479100777/#

In fact in September last year, Paul Krugman already tried to examine this issue in his long-winded column “How Did Economists Get It So Wrong?”:-

“In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place.”

“Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system. If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision — that of a market economy that has many virtues but that is also shot through with flaws and frictions.”

“There’s already a fairly well developed example of the kind of economics I have in mind: the school of thought known as behavioral finance. Practitioners of this approach emphasize two things. First, many real-world investors bear little resemblance to the cool calculators of efficient-market theory: they’re all too subject to herd behavior, to bouts of irrational exuberance and unwarranted panic. Second, even those who try to base their decisions on cool calculation often find that they can’t, that problems of trust, credibility and limited collateral force them to run with the herd.”

“Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: ‘There is always an easy solution to every human problem — neat, plausible and wrong.’”

“When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right.”