Reinventing economics: time for a more realistic approach.

• Author: Shiller, Robert J.

The widespread failure of economists to forecast the financial crisis that erupted in 2008 has much to do with faulty models. This lack of sound models meant that economic policymakers and central bankers received no warning of what was to come.

As George Akerlof and I argue in our recent book Animal Spirits, the current financial crisis was driven by speculative bubbles in the housing market, file stock market, and energy and other commodities markets. Bubbles are caused by feedback loops: rising speculative prices encourage optimism, which encourages more buying, and hence further speculative price increases--until the crash comes.

But you won't find the word "bubble" in most economics treatises or textbooks. Likewise, a search of working papers produced by central banks and economics departments in recent years yields few instances of "bubbles" even being mentioned. Indeed, the idea that bubbles exist has become so disreputable in much of the economics and finance profession that bringing them up in an economics seminar is like bringing up astrology to a group of astronomers.

The fundamental problem is that a generation of mainstream macroeconomic theorists has come to accept a theory that has an error at its very core: the axiom that people are fully rational. And as the statistician Leonard "Jimmie" Savage showed in 1954, if people follow certain axioms of rationality, they must behave as if they knew all the probabilities and did all the appropriate calculations.

So economists assume that people do indeed use all publicly available information and know, or behave as if they knew, the probabilities of all conceivable furore events. They are not influenced by anything but the facts, and probabilities are taken as facts. They update these probabilities as soon as new information becomes available, and so any change in their behavior must be attributable to their rational response to genuinely new information. And if economic actors are always rational, then no bubbles--irrational market responses--are allowed.

But abundant psychological evidence has now shown that people do not satisfy Savage's axioms of rationality. This is the core element of the behavioral economics revolution that has begun to sweep economics over the last decade or so.

In fact, people almost never know the probabilities of future economic events. They live in a world where economic decisions are fundamentally ambiguous, because the future doesn't seem to be a mere...