I recently received an email from a Vanguard mailing list and one of the articles was called “Why So Many Americans Are Broke”. One of the reasons it made was that when it comes to money, people are not as rational as many economists think. The statement reiterates the New York Times article read “How Did Economists Get It So Wrong” by Paul Krugman. In Krugman’s article, he points that freshwater economists (neoclassical purists) assume that people are rational and therefore markets work. In both the Vanguard and Krugman’s articles, they provided evidence based on small economic experiments to disprove the notion that people are rational with money. Furthermore, the Vanguard article also states that even students in Ivy League schools made mistakes when it comes to handling money.
I think the neoclassical purists assumption that people are rational with their money with the information they are given and therefore markets work is a bold claim. First, people are not often times rational themselves so how can they be rational with money? However, people do rationalize or at least find ways to justify their irrational behavior which is ironic. Secondly, the information they are given can vary in terms of accuracy, completeness, or plain bias. Impulsive purchases or buyers remorse are also simple examples of emotions being involved with money. Thirdly, the state of the economy has also to do with externalities beyond the individual such as weather, global catastrophe, technology, politics, war and many other factors that make it much more difficult to predict or fit into a math formula.
The other interesting story behind both the Vanguard and NYTimes article involves students from the highest ranked education institutions. Smart students can also make mistakes with money or are simply taught outrageous theories on economics really concerns me because these students will eventually be put in positions of trust and power as financial planners, work on Wall street, or create economic policies. Disastrous consequences, that could lead us to another Great Recession or Depression, could be results of students with very narrow, wrong, or incomplete views of the economy due to their education. In fact, our deep Recession we are going through today is a direct result of a false Appeal to Authority. In Krugman’s article, the Federal chairman Alan Greenspan at the time did not believe a housing bubble was brewing because he believed that modern financial economics had it under control and free markets would correct itself. The lack of foresight from individuals put in positions of power allowed the burst of the housing bubble that has caused trickle down financial crisis leading to our current Recession.
