Tuesday, September 8, 2009

The Current Financial Collapse

I came across an interesting write up discussing contemporary economics and the majority of influential economists failed to foresee the recent economic problems caused by the financial system collapse.

Hindsight is always 20/20, but I knew in the last few years that the real estate market was highly overvalued. I didn't know why (all the shady lending stuff) at the time, but I knew that the system made no sense. How did I know? Because my parents were suggesting that I look into buying a house for all the usual reasons (long term investment, etc).

I looked around at houses in Orange County and I was pretty shocked at how unaffordable houses are. My income isn't super high, but in my opinion, a software engineer such as myself should be able to afford a reasonable house. When I looked around, I saw opportunities to pay $600,000 for a small 2 bedroom townhouse. The 2 bedroom condo unit I was living in, which wasn't in great condition, was on the market for around $380,000.

My personal view of the value of these types of properties was that they were simply not worth the money. It turns out I was right. The ketchup analogy (where if two ounces of ketchup cost twice as much as one ounce, then the ketchup prices must make sense) is a great way to understand that people were simply comparing relative values of houses without thinking enough about the absolute value of houses.

The article describes how many current economists put all their faith in the rationality of people with their money. If this were the case, people would not gamble in casinos where their expected return value is obviously lower than the money they spend (or else you wouldn't see billion dollar casinos flourishing in Las Vegas). The business model of casinos basically boils down to being flashy and letting people come hand you money and you just give back some of it randomly.

The total rationality of people with their money is clearly false. People are subjective creatures and all decisions we make are subjective. Given this, it's easy to see how people would be swayed by these conventional wisdoms that the housing market is a good, stable investment and would consequently over invest in it.

Economists re-evaluate their economic models on a more realistic model where people are somewhat irrational creatures that are not all equally adept with their money. Psychology should be core coursework when studying economics.

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