Bounded rationality

Robert Shiller (writing in the Financial Times) identifies the failure to control the animal spirits of financial markets as the key cause of the financial crisis. The Economist's Economics A-Z calls animal spirits the "colourful name that Keynes gave to one of the essential ingredients of economic prosperity: ... 'naive optimism'." In modern economics such behavior is often referred to as boundedly rational. Here is Robert Shiller's explanation of the problem:

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. more...

In other words: actors in financial markets are only boundedly rational and thus government has the duty to prevent - through appropriate regulation - that they take decisions that could be harmful for themselves, for others and for the market economy as a whole. In brief:

It is the role of the government ... to regulate asset markets so that people are not falsely lured into buying snake-oil assets. more...

See also Robert Shiller's and George Akerlof's new book on Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.