There is much evidence that people are not rational, in the economist’s sense; nor do they take into account expectation, in the precise interpretation of that word. As a result economic theory often does not correspond with what happens in the market. Some would argue that we need descriptive economics. I would argue that all should be taught about probability, utility, and MEU (maximization of expected utility) and act accordingly.

[M]ost economists were caught completely by surprise by the 2008 global financial crisis. ...[T]hey have not been able to come up with solutions to the ongoing aftermaths ...[E]conomics seems to suffer from a serious case of megalomania—how can a subject that cannot... explain its own area... claim to explain (almost) everything?

The reason why economics has given such a poor account of the origins of the crisis is that there is something essentially incompatible between the economist's view of individual rationality and systemic collapse. Without adding qualifications which strain their logic, economists cannot readily get from their picture of the the individual maximizing his utilities to booms and slumps and the persistence of depressions.

So why were economists so wrong? The problem is that economics is an axiomatic theory, it's deductive, based on assumptions almost all of which are false [with] too many omitted factors, and they don't care about contradictions. They don't care about people killing themselves... That's not an economic problem.

So what's the moral? We've seen how the insistence on models that meet the standards of rigor in mainstream economics can lead to neglect of clearly valuable ideas. Does this mean that the whole emphasis on models is wrong? Should we make a major effort to open up economics, to relax our standards about what constitutes an acceptable argument? No—the moral of my tale is nowhere near that easy. Economists can often be remarkably obtuse, failing to see things that are right in front of them. But sometimes a bit of obtuseness is not entirely a bad thing.

I think I’m starting to resolve a puzzle that’s been bugging me for awhile.
Pop economists (or, at least, pop micro-economists) are often making one of two arguments: 1. People are rational and respond to incentives. Behavior that looks irrational is actually completely rational once you think like an economist.
2. People are irrational and they need economists, with their open minds, to show them how to be rational and efficient.
Argument 1 is associated with “why do they do that?” sorts of puzzles. Why do they charge so much for candy at the movie theater, why are airline ticket prices such a mess, why are people drug addicts, etc. The usual answer is that there’s some rational reason for what seems like silly or self-destructive behavior.
Argument 2 is associated with “we can do better” claims such as why we should fire 80% of public-schools teachers or Moneyball-style stories about how some clever entrepreneur has made a zillion dollars by exploiting some inefficiency in the market.
The trick is knowing whether you’re gonna get 1 or 2 above. They’re complete opposites!

Using the popular macroeconomic models of the time, Lucas and Sargent showed how replacing traditional assumptions about expectations formation by the assumption of rational expectations could fundamentally alter the results.... Most macroeconomists today use rational expectations as a working assumption in their models and analyses of policy. This is not because they believe that people always have rational expectations. Surely there are times when people, firms, or financial market participants lose sight of reality and become too optimistic or too pessimistic... But these are more the exception than the rule, and it is not clear that economists can say much about those times anyway. When thinking about the likely effects of a particular economic policy, the best assumption to make seems to be that financial markets, people, and firms will do the best they can to work out the implications of that policy. Designing a policy on the assumption that people will make systematic mistakes in responding to it is unwise.

I will tell you a secret. Economists are supposed to be dry-as-dust, dismal fellows. This is quite wrong, the reverse of the truth. Scratch a hard-boiled economist of the libertarian persuasion and you find a Don Quixote underneath. No lovesick maiden ever pined for the days of medieval chivalry with such sentimental impracticality as some economists long for the return to a Victorian marketplace that is completely free. Completely free? Well, almost so. There must, of course, be the constable to ensure that voluntary contracts are enforced and to protect the property rights of each molecule which is an island unto itself.

Having written all that, I must admit that there is some soul searching going on in the economics profession. As obvious as the financial crisis seems after the fact, few economists saw it coming (with some notable exceptions). Virtually none anticipated how severe it might be. In the fall of 2005, several prominent economists wrote in a prestigious journal, “As of the end of 2004, our analysis reveals little evidence of a housing bubble.”
Wrong. Actually the article was worse than wrong, because it was written explicitly to refute the signs of a bubble that had become obvious to many laypeople—which is kind of like the fire department showing up at a house with smoke wafting from the roof and declaring, “No, that’s not a fire,” only to have flames start leaping from the attic twenty minutes later. There was a bubble. And it can be explained best by incorporating psychology into economics, namely the tendency of individuals to believe that whatever is happening now is what’s most likely to happen in the future.

In Economics as almost everywhere else, with all our cleverness, we have become decidedly less wise, while knowing more and more about less and less. We have lost the sense of proportion—so indispensable for every economist—while analysing the curiosities of hypothetical economic situations and forgetting what has a bearing on real economic life. In spinning out the fine threads of the New Economics, we forget the most elementary principles of economics, and while stressing what might at best in highly exceptional circumstances we overlook what are almost perennial truths. While proudly parading our elaborate equations we unlearnt that simple common sense which consists in reckoning with human reactions and institutions as they really are.

When the economy is in a depression, scarcity ceases to rule. Productive resources sit idle, so that it is possible to have more of some things without having less of others; free lunches are all around. As a result, all the usual rules of economics are stood on their head; we enter a looking-glass world in which virtue is vice and prudence is folly. Thrift hurts our future prospects; sound money makes us poorer. Moreover, that's the kind of world we have been living in for the past several years, which means that it is a kind of world that students should understand. […] Depression economics is marked by paradoxes, in which seemingly virtuous actions have perverse, harmful effects. Two paradoxes in particular stand out: the , in which the attempt to save more actually leads to the nation as a whole saving less, and the less-well-known , in which the willingness of workers to protect their jobs by accepting lower wages actually reduces total employment. […] In times of depression, the rules are different. Conventionally sound policy—s, a firm commitment to —helps to keep the economy depressed. Once again, this is not normal. Most of the time we are not in a depression. But sometimes we are—and 2013, when this chapter was written, was one of those times.

I would summarize the Keynesian view in terms of four points: 1. Economies sometimes produce much less than they could, and employ many fewer workers than they should, because there just isn’t enough spending. Such episodes can happen for a variety of reasons; the question is how to respond.
2. There are normally forces that tend to push the economy back toward full employment. But they work slowly; a hands-off policy toward depressed economies means accepting a long, unnecessary period of pain.
3. It is often possible to drastically shorten this period of pain and greatly reduce the human and financial losses by “printing money”, using the central bank’s power of currency creation to push interest rates down.
4. Sometimes, however, monetary policy loses its effectiveness, especially when rates are close to zero. In that case temporary deficit spending can provide a useful boost. And conversely, fiscal austerity in a depressed economy imposes large economic losses.