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Wednesday, September 30, 2009

Enligthened Economics: Not So Rational


In a very interesting September 2 New York Times Magazine article, Nobel Prize winner and liberal economist Paul Krugman discussed the development of economic thought over the past 230 years and how the current financial crisis has thrown economic theory into disarray. Krugman makes a case that almost all economists, whether they be conservative or liberal, financial or macroeconomic, missed the current economic crisis. Despite their impressive-looking mathematical formulas and hundreds of years of history, economists, in general, failed to predict the size and timing of our current worldwide maelstrom, and, worse yet, were generally blind to the idea that a catastrophe of this size could even happen in this day and age.

Krugman says economists, "Will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic 'theory of everything' is a long way off." In short, he says we have to "live with messiness."

From a practical standpoint, it reiterates the importance of knowing that the financial markets are not perfectly rational and that they do not always behave in the way that econometric models predict. One could argue that changes in the financial markets are simply a reflection of the sentiments, fears, dreams, and hopes of us - the market participants. The markets are not separate from us - they are us!

Since we are human, the markets may behave in a way that reflects human behavior and that can get quite messy. Some of us are rational beings while others are not so much enlightened as opposed to emotional, subjective, and irrational.

“There is nothing so disastrous as a rational investment policy in an irrational world”
John Maynard Keynes

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