Warburton: So what you’re saying is that traditional economics has focused on an ideally rational individual, asking, “What would such a person do if he or she behaved in their own best interests based on the information available?” But behavioral economics brings in the fact that we don’t always behave in our own best interests.
Shiller: That’s right. Conventional economics misrepresents what our best interests are. A great example is the financial crisis that began in 2007. The way it began was home prices started falling rapidly. Many people had committed themselves to mortgages and now the debt was worth more than the house was worth; they couldn’t come up with the money to pay off the mortgage, and it led to a world financial crisis. So why did that happen? Conventional economic theory can’t seem to get at the answer, which I would say is that we had a speculative bubble driven by excessive optimism, driven by public inattention to risks of such an eventuality, and errors in managing the mortgage contracts that were made. There are no errors in conventional economics: it’s all rational optimization.
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