Economists have said and written a lot about market failures and government failures, but is it now time to also consider a more fundamental type of economic failure that is embedded in our minds: human failure?

The usual theories of business cycles tell us that economic output fluctuates because participants in an economy cannot quickly adjust their choices after an exogenous shock to the system, such as a change in demand or a new technology. One of the earliest theories of business cycles linked them to sunspots that increased or decreased agricultural output. In that sense, the ebbs and tides in economic fortunes are highly dependent on outside factors.

But the recent financial crisis and global recession seems to have encouraged some economists to look inward into the working of the human mind. Here, I offer three recent examples of such attempts to weave psychology into economic thinking.

In a recent article in The New York Times, Yale University economist Robert Shiller asked whether economic downturns and recoveries are self-fulfilling prophecies. It is well known that the average post-war US recession has lasted around two years and hence people have now started thinking that it is time for the current recession to end. This piece follows an earlier syndicated column by Shiller where he argued: “We can only wish that formulating economic policy were as clear-cut as, say, mechanical engineering. It is not: a host of poorly understood natural cyclical factors play a role, and so do the vagaries of human psychology."

Another recent provocative piece on a similar issue is by Paul De Grauwe of the University of Leuven in Belgium. He argues that economists could not anticipate the financial crisis because they made extraordinary assumptions in their macroeconomic models about the cognitive abilities of human beings. Modern psychologists and behavioural economists have shown that humans can understand bits and pieces of the world, and hence depend on simple rules or heuristics to make choices. Correlations in such beliefs tend to create waves of optimism and pessimism that we see above all in the financial markets.

But standard economic models assume that humans are perfect calculating machines. De Grauwe calls for a bottom-up macroeconomics. “The bottom-up model has agents who experience an informational problem. They do not fully understand the nature of the shock or its transmission. They use a trial-and-error learning process aimed at distilling information. This process leads to waves of optimism and pessimism, which in a self-fulfilling way create business cycle movements. Booms and busts reflect the difficulties of economic agents trying to understand economic reality," he says. In this way of looking at the world, economic cycles are caused by endogenous factors rooted in human cognitive limitations.

Even economic policymakers are not immune, not so much to individual psychology but to national ideology. That’s where the third recent paper, by Alex Cukierman of the University of Tel Aviv, comes in. “Four classes of (partially overlapping) factors affect policy choices: Ideology, policymaking institutions, politics and accepted economic knowledge. Ideology determines the broad long-term objectives to which policymakers of a nation aspire. Although, due to various constraints, those objectives are seldom fully achieved, they constitute an important input into attempts at forecasting policy responses. For example, the belief in democracy and the allocative efficiency of private enterprise is a core characteristic of Western ideology, while the currently held belief in free enterprise subject to tight control by ruling elites characterizes contemporaneous China", writes Cukierman.

It is now seven years since Daniel Kahneman was awarded the Nobel Prize in economics “for having integrated insights from psychological research into economic science, especially concerning human judgement and decision making under uncertainty". But the insights from his research—and those of many other behavioural economists—have not been fully integrated into mainstream macroeconomics, which still leans more heavily on theoretical elegance rather than messy realities.

It is still not clear what the policy implications of this emerging paradigm are. We have seen how the economic mood changes in tandem with asset prices: Rising equity prices make consumer feel wealthier and companies more adventurous, while falling markets reverse the process. Does that mean that governments and central banks should pay more attention to asset prices?

De Grauwe mentions one possibility: “In a world where waves of optimism and pessimism (animal spirits) can exert an independent influence on output and inflation, it is in the interest of the central banks not only to react to movements in inflation but also to movements in output and asset prices so as to reduce the booms and busts that free market systems produce quite naturally."

Niranjan Rajadhyaksha is managing editor of Mint. Your comments are welcome at