Misguided economic theories caused the crisis..

The global financial and economic crisis is causing a lot of hardship among ordinary people. How did we get into this mess, while our financial systems were run and regulated by supposedly very smart people?

Robert Shiller, professor of economics at Yale University, shared his ideas in a recent article appearing in the Financial Times. He argued that we underestimated the role of animal spirits (greed, fear, and overconfidence in our ability to predict) in directing our policies and that governments indeed have a very important balancing role to play to make capitalism stable:

We are seeing, in this financial crisis, a rebirth of Keynesian economics. We are talking again of his 1936 book The General Theory of Employment, Interest and Money, which was written during the Great Depression. This era, like the present, saw many calls to end capitalism as we know it. The 1930s have been called the heyday of communism in western countries. Keynes's middle way would avoid the unemployment and the panics and manias of capitalism. But it would also avoid the economic and political controls of communism. The General Theory became the most important economics book of the 20th century because of its sensible balanced message.

In times of high unemployment, creditworthy governments should expand demand by deficit spending. Then, in times of low unemployment, governments should pay down the resultant debt. With that seemingly minor change in procedures, a capitalist system can be stable. There is no need for radical surgery on capitalism.

The General Theory also had a deeper, more fundamental message about how capitalism worked, if only briefly spelled out. It explained why capitalist economies, left to their own devices, without the balancing of governments, were essentially unstable. And it explained why, for capitalist economies to work well, the government should serve as a counterbalance.

The key to this insight was the role Keynes gave to people's psychological motivations. These are usually ignored by macroeconomists. Keynes called them animal spirits, and he thought they were especially important in determining people's willingness to take risks. Businessmen's calculations, he said, were precarious: "Our basis of knowledge for estimating the yield 10 years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing." Despite this, people somehow make decisions and act. This "can only be taken as a result of animal spirits". There is "a spontaneous urge to action".

There are times when people are especially adventuresome - indeed, too much so. Their adventures are supported in these times by a blithe faith in the future, and trust in economic institutions. These are the upswing of the business cycle. But then the animal spirits also veer in the other direction, and then people are too wary.

Social psychologists, notably Roger Schank and Robert Abelson, have shown how much stories and storytelling, especially human-interest stories, motivate much of human behaviour. These stories can count for much more than abstract calculation. People's economic moods are largely based on the stories that people tell themselves and tell each other that are related to the economy.

We have seen these stories come and go in rapid succession in recent years. We first had the dotcom bubble and the envy-producing stories of young millionaires. It burst in 2000, but was soon replaced with another bubble, involving smart "flippers" of properties.

This mania was the product not only of a story about people but also a story about how the economy worked. It was part of a story that all investments in securitised mortgages were safe because those smart people were buying them. Those enviable people who are buying these assets must be checking on them, therefore we do not need to. We need only run alongside them.

What allowed this mania and these stories to persist as long as they did? To a remarkable extent we have got into the current economic and financial crisis because of a wrong economic theory - an economic theory that itself denied the role of the animal spirits in getting us into manias and panics.

According to the standard "classical" theory, which goes back to Adam Smith with his Wealth of Nations in 1776, the economy is essentially stable. If people rationally pursue their own economic interests in free markets they will exhaust all mutually beneficial opportunities to produce goods and exchange with one another. Such exhaustion of opportunities for mutually beneficial trade results in full employment.

Classical theory also tells us that financial markets will also be stable. People will only make trades that they consider to benefit themselves. When entering financial markets - buying stocks or bonds or taking out a mortgage or even very complex securities - they will do due diligence in seeing that what they are buying is worth what they or paying, or what they are selling.

What this theory neglects is that there are times when people are too trusting. And it also fails to take into account that if it can do so profitably, capitalism will produce not only what people really want, but also what they think they want. It can produce the medicine people want to cure their ills. That is what people really want. But if it can do so profitably, it will also produce what people mistakenly want.

It will produce snake oil. Not only that: it may also produce the want for the snake oil itself. That is a downside to capitalism. Standard economic theory failed to take into account that buyers and sellers of assets might not be taking due diligence, and the marketplace was not selling them insurance against risk in the complex securities that they were buying, but was, instead, selling them the financial equivalent of snake oil.

There is a broader moral to all this - about the nature of capitalism. On the one hand, we want to take advantage of the wisdom of Adam Smith. For the most part, the products produced by capitalism are what we really want, produced at a price that we are willing and able to pay. On the other hand, when confidence is high, and since financial assets are hard to evaluate by those who are buying them, people will and do buy snake oil. And when that is discovered, as it invariably must be, the confidence disappears and the economy goes sour.

It is the role of the government at two levels to see that these events do not occur. First, it has a duty to regulate asset markets so that people are not falsely lured into buying snake-oil assets. Such standards for our financial assets make as much common sense as the standards for the food we eat, or the purchase medicine we get from the pharmacy. But we do not want to throw out the good parts of capitalism with the bad. To take advantage of the good parts of capitalism, when fluctuations occur it is the role of the government to see that those who can and want to produce what others want to buy can do so. It is the role of the government, through its counterbalancing fiscal and monetary policy, to maintain full employment.

The principles behind such an economy are not the principles behind a socialist economy. The government insofar as possible is only creating the macroeconomic conditions that will allow the economy to function well.

That is the role of government. Its role is to ensure a "wise laisser faire ". This is not the free-for-all capitalism that has been recommended by the current economic theory, and seems to have been accepted as gospel by economic planners, and also many economists, since the Thatcher and Reagan governments. But it also is a significant middle way between those who see the economic disasters and unemployment of unfettered capitalism, on the one hand, and those who believe that the government should play no role at all.

The idea that unfettered, unregulated capitalism would invariably produce the good outcomes was a wrong economic theory regarding how capitalist societies behave and what causes their crises. That wrong economic theory fails to take account of how the animal spirits affect economic behaviour. It fails to take into account the roles of confidence, stories and snake oil in economic fluctuation.