Editor's note: Robert J. Shiller is a professor of economics at Yale University. This op-ed is based on his book with George Akerlof, "Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism." Akerlof is a 2001 Nobel laureate in economics and professor of economics at the University of California at Berkeley.



Robert Shiller says basic psychogical factors led to excesses which have devastated the economy.



(CNN) -- President Obama's National Economic Council head Lawrence Summers noted in his speech March 13 that the economic crisis has led to an "excess of fear" that must be reversed.



To understand the role fear plays in the current crisis, we must understand the role of human psychology.



John Maynard Keynes thought psychology was the major cause of economic booms as well as busts, though this aspect of his work is now largely forgotten. He said people's economic decisions, in both good times and bad times, are largely, ultimately, if indirectly, driven by animal spirits, primitive psychological tendencies.



In a recently published book, George Akerlof and I identified three animal spirits that played critical roles in the current economic meltdown. They are confidence, bad faith and storytelling.



Let's first consider confidence and its dictionary meaning. Confidence means complete and secure trust. But trust goes beyond the rational use of information that is usually considered in economic theory. Trust is largely an emotion. Indeed we saw the role of vivid emotions in the stock and housing market booms that brought on our current problems.



Trust is a state of mind that is the opposite of vigilance. People were purchasing and selling complex financial instruments without looking carefully at them. This trust is broken.



The second animal spirit that came into play was bad faith. With so many trusting people, an uglier side of human nature became prominent. The temptation for smart promoters was overwhelming.



Questionable practices boomed, and regulators failed to step in, because of the view, taken from economists, that private markets would be self-policing. Investors would only put their money at increased risk if they were duly compensated by higher expected returns. Thus, there was little worry about laxity of regulation in securities and real estate markets.



But, this self-policing view did not consider that these investors might be overconfident.



There is a myth that capitalism produces what people really want, as long as firms can make a profit. But, instead, more generally, it produces what people think they want, as long as firms can make a profit.



True, unregulated capitalism will produce good medicines that cure our ills. But unregulated capitalism will also produce snake oil that people think they want, but does not cure our ills. (To guard against the production of such things, the federal government established the Food and Drug Administration in 1906.)



The problem of snake oil has special relevance for financial assets, which are only pieces of paper. Most investors can surmise their value only from what others, such as accountants and rating agencies, tell them. These accounting and rating agencies also have their own incentives. And those incentives have not been fully aligned with the public's interest. And so when people are overconfident, financial markets produce assets that take advantage of that overconfidence.



If unprotected by effective regulation, people will be sold snake oil assets. Just recently an industry arose, in Wall Street and beyond, to produce them.



A third animal spirit bolstered the previous two. People act and think and live according to stories, especially human interest stories, not usually abstract calculation. That goes for their personal decisions. But there is also always a story, usually with some grain of truth and human interest, about the economy.



These stories are often overly exuberant, on the one side, or overly pessimistic on the other. Ten years ago we had the story of the dot-com millionaires. Most recently we believed alchemists of financial engineering were packaging risky financial assets to make them safe.



People were overconfident. And markets took advantage of their beliefs to sell them
Basic psychological factors are key to to what? Who said that the government must aim for full employment and widely available credit? Who says that the government has a role in preventing fraud from being sold to the public? What is Robert Shiller known for? What is Shiller's first name?
excesses Robert Shiller Robert Shiller professor of economics at Yale University. Robert
question: Basic psychological factors are key to to what?, answer: excesses | question: Who said that the government must aim for full employment and widely available credit?, answer: Robert Shiller | question: Who says that the government has a role in preventing fraud from being sold to the public?, answer: Robert Shiller | question: What is Robert Shiller known for?, answer: professor of economics at Yale University. | question: What is Shiller's first name?, answer: Robert