Animal Spirits, by Shiller and Akerlof: Questioning Economic Motives 20 comments
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The book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, by George A. Akerlof and Robert J. Shiller, is getting a lot of attention. One of the reasons for this attention is that the book is co-authored by Bob Shiller, an economist whose name seems to be appearing everywhere these days from television talk shows to the op-ed pages of the Wall Street Journal. George Akerlof is not so well known outside of the economics profession, but he did win a Nobel Prize in economics so he is not a person to be taken lightly. A second reason for the attention is that a great search is going on to discover reasons for the current economic and financial collapse. This book provides a coherent rationale for the collapse, although I disagree with it.
The Akerlof/Shiller hypothesis is “that much of economic activity is governed by animal spirits.” People’s “animal spirits” are defined as the “noneconomic motives” they use when making decisions. The basic model of market-based economics assumes that people make decisions in a rational way based upon “economic motives”. Although this latter model works well much of the time, it does not work as effectively as it could, especially in dynamic or changing situations. As a consequence, Akerlof and Shiller argue that the basic model would explain events and situations much better, like the current economic and financial collapse, if it allowed for a consideration of the “noneconomic motives” of people. Irrational behavior must be taken into consideration.
The alternative conclusion to the approach presented in this book? Economists that don’t rely on the Akerlof/Shiller model must assume that “economic events are driven by inscrutable technical factors or erratic government action.” These other economists must assume that either the economy is deterministic in nature or that government policy makers can make mistakes. Certainly we don’t want to be considered so foolish as to assume either one of these things…do we?
In Part One of the book, Akerlof and Shiller define the “noneconomic motives” that they consider to be major influences on people making economic decisions. These motives are confidence, fairness, corruption and bad faith, money illusion, and stories. By confidence they mean that investors will become more confident about the direction that markets are moving as the movement in one direction or the other gains volume and speed; fairness applies to how people believe they are treated as in whether or not wages should be cut; corruption relates to how people take advantage of others when the opportunity arises; money illusion means that people make some decisions based on nominal values and not real values as the mainline macroeconomic model assumes; and people will base their decisions on the stores that they know that are relevant to their situation.
In Part Two of the book, the authors incorporate their theory of “animal spirits” into the analysis of various macroeconomic situations to show how useful it is to the interpretation of markets and historical events. Specifically, the authors discuss the economics of depression, central bank decisions, labor markets, the inflation/unemployment tradeoff, consumer savings habits, the volatility of financial markets, and real estate market cycles.
Their conclusion: “We have seen that our interpretation of the economy passes the test.” And, “Our theory of animal spirits provides an answer to a conundrum: Why did most of us utterly fail to foresee the current economic crisis?” That is, Akerlof and Shiller are right and those that use the standard economic model are wrong.
This conclusion leads to a policy prescription: “Without intervention by the government the economy will suffer massive swings in employment. And financial markets will, from time to time, fall into chaos” since “all of the animal spirits tend to drive the economy sometimes one way and sometimes another.” That is, because animal spirits cause markets to fluctuate more excessively than the basic market-based model allows, government must play a greater role in the economy than proposed by those who rely solely on this latter model. Of course, government action is always the solution and is always carried out in an appropriate manner. Right?
Let me take the other side of the argument: I don’t believe that good economists ignore animal spirits or “noneconomic motives” in their economic analysis. It is just that animal spirits enter into economic decisionmaking in an irregular and unpredictable manner. I would argue that animal spirits are at least as unpredictable as “erratic government action”, if not more so. This is a major problem that all researchers face when building models in any field of study. In order to build models, researchers must search out those factors that, in a particular situation, play as systematic a role as possible. Professional research does not arbitrarily exclude other factors like animal spirits or government action when they build their models. They just build their models using the factors that impact results in the most regular and consistent manner. Irrational behavior, by definition, is neither regular nor coherent!
Everyone uses models in decisionmaking. We must, in some way, make predictions about what outcomes we might expect, given the different choice of decisions we have at our disposal. But, we work in a world of incomplete information. Thus, the models we use to make these predictions are themselves incomplete and must be probabilistic in nature. They don’t include all the things that might impact the outcomes, like “animal spirits.” (And, they are not deterministic, thereby excluding the Akerlof/Shiller accusation that some economists believe that outcomes are events that “are driven by some inscrutable technical factors.”)
Furthermore, the models that we use are relatively adequate and not absolutely adequate. That is, the models we use need to be logically consistent and be able to predict at least as well as any other logically consistent model. By definition, irrational behavior can produce contradictory predictions and, hence, are not logically consistent.
And, these models are not absolutely adequate in that they are fallible. They include those things that systematically impact outcomes and which produce relatively adequate predictions on a regular basis. It is not that confidence, fairness, corruption and bad faith, and money illusion do not impact outcomes. It is just that in building a logically consistent model, these factors fail to contribute in a regular fashion. They should not be ignored, but they must be added intuitively to the analysis not systematically. And all individuals use stories as a predictive methodology. Stories are just another form of model we all use to make predictions in situations that are very complex and cannot be formally modeled in any other way.
In conclusion let me say that I strongly urge people to read this book. Akerlof and Shiller are important analysts and whether or not one agrees with them, their efforts are worthy of consideration. If nothing more, their arguments cause you to think hard about where you stand and help you to strengthen your own arguments. As is obvious, I don’t fully agree with them and I place greater emphasis than they do upon “erratic government action.” For example, in explaining the housing bubble of the 2000s, Akerlof and Shiller credit the Bush -43 tax cuts passed in June 2001 and the Fed’s reductions in the discount rate with jump-starting the economic recovery from the 2001 recession. After these two actions, according to our authors, animal spirits took over and drove the credit bubble. Nothing else! They make no mention that the Fed kept the real short term interest rate negative for almost 2 years! But that is my story…and not theirs.
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This article has 20 comments:
The work of nassim Taleb (sp) fit well it this branch of finance because animal spirits explains fat tails and why systems need to be dumb and robust instead of complicated. In other words the systems need to be able to withstand the foolishness of man.
Here's the problem, in the absence of government intervention, self-serving government and private sector egomaniacs will pummel the submissive sheep. Good government intervention requires that ALL markets be transparent and as liquid as possible. There would be no government or companies too big to fail because that would imply market power to impose opacity and illiquidity.
Transactions cannot be made in the context of asymmetric information and/or control.
The second part of the problem is that the act of maintaining symmetric markets inherently allows self-serving actions by those in government. These public sector executives can extract toll from private sector parties in order for the private sector executives to maintain some asymmetry.
The trick to maintaining symmetries, then, would be to limit the size of government on the public sector side and limit the size of market share on the private sector side.
Hell, trust busting only occurs because self-serving government officials don't want self-serving private sector officials to have more power than they do!
The alternative conclusion to the approach presented in this book? Economists that don’t rely on the Akerlof/Shiller model must assume that “economic events are driven by inscrutable technical factors or erratic government action.” These other economists must assume that either the economy is deterministic in nature or that government policy makers can make mistakes. Certainly we don’t want to be considered so foolish as to assume either one of these things…do we?
Greenspan didn't think the markets would act the way they did. destroy their own companies for greed. it shocked him (that is one aspect of animal spirits). the gaming of regulators who give bankers what they want for self gain is part of animal spirits. greenspans fault lied in thinking the markets were rational (chicago school). there is a type of rational behavior to animal spirits, but the rational is emotional. gov't policy is made by peope, people have animal spirits and are influenced away from the rational by interest groups. all part of same thing.
Excellent review. I have two comments to add.
1. The motives you describe are "confidence, fairness, corruption and bad faith, money illusion, and stories". Governments and markets are both composed of people and therefore both have motives, as well as animal spirits. Sometimes government is in conflict with market participants and sometimes reinforcing. The reinforcement can be, at times, in unintended ways. Your review suggests that the authors have not developed this idea completely. (See the final paragraph of your review.)
2. You wrote: "Furthermore, the models that we use are relatively adequate and not absolutely adequate. That is, the models we use need to be logically consistent and be able to predict at least as well as any other logically consistent model. By definition, irrational behavior can produce contradictory predictions and, hence, are not logically consistent."
I think you should have mentioned the possibility of false premises based on modelling to historical data. The ability to predict the future based on the past is fraught with peril. How can we know if models are "logically consistent and ... able to predict at least as well as any other logically consistent model?" The future has not happened yet. Models can not be overly depended on to predict the future, but, in reality, only best be used to understand how out of sample situations differ from the in sample model data. Models are only be evaluated for logical consistency when looking at what has already happened. When making projections about the future, they fall in the category of educated guesses.
they build a model, the goal of the book is to describe events by that model. it is what everyone does. the purpose of the book is to do exactly what you describe above. I would say the point is that models need to be much more careful and take into account 6 sigma events which create fat tails. chicago school with fat tails. not normal distribution. One could argue that greenspan (which I view someone who made major mistakes) overly fearing deflation (an animal spirit) kept interest rates too low and many people jumped on the housing bandwagon (animal spirit). the point is that you need both actions.
Bernanke's irrational fear of deflation (animal spirit) is going to cause havoc in our markets in the future. he will over react to his bigger fear (AN ANIMAL SPIRIT) and we will be screwed. spirits do not have to take the form of mass behavior only, they function at the individual policy maker level as well.
As for the book being reviewed, if Robert Shiller was not been an author, I wouldn't get near it with a barge pole. George Akerlof is almost certainly a very smart man, but he had about as much right to a Nobel as President Jed Bartlett on the West Wing.
And also why are governments less prone to "animal spirits." I would say they are more prone to them. The argument touted, as I see it, is that we need more government to fix the problems that government has created. There may be some sense in that, but I would desire as a goal to create markets that are not regulated and only use government to get there. In other words, if you fix the locus of the problem in "animal spirits" then you make the case for government intervention, and if you posit the problem as one of government intervention, then you decrease the role of the government.
Jerry Klein RIA
Let's also not forget that the liberal concept of giving home loans to people who couldn't pay them back and additionally not requiring any down payment may be the greatest contributor to the mortgage security collapse that brought down the world economies.
"This conclusion leads to a policy prescription: “Without intervention by the government the economy will suffer massive swings in employment."
I wonder whether some people in Washington might have an interest in that...
If players in the market get it wrong, there are self-correcting mechanisms in the market place. However, as we've seen, these feedbacks can be horribly lumpy and slow - particularly when entangled with moral hazard created by government.
When government decision makers get it wrong, the feedback mechanisms are the media and elections. Apart from their lumpy and uncertain nature, these feedback mechanisms to government are themselves are highly prone to animal spirits - leading to the sort of feeding frenzies one sees in the media and politics and the tendency for societies under pressure to end up with extremist leaders (Hitler was elected). Finally, the deep pockets and powers of government mean that it can fail upwards - mistakes being dealt with by more money, more troops, more regulation.
Conclusion: more government means more problems with animal spirits, not less.
The point they are making is that economics is not a science, at least not in the sense of Popper. As someone who has a masters degree in economics, I promise you that it has been difficult for me to accept this.
The difference is the following: the fundamental requirement of the natural sciences is that in order to develop a useful hypothesis, the data is independent of the observer.
This allows us to form hypotheses that can be tested, and, if true, can be used to make predictions and provide explanations. It allows us to develop mathematical models and make pretty precise predictions.
Economics tries to do this by instituting conditions such as "perfect competition", "utility maximization", "perfect knowledge", "no excess profits".
These are all essential to make sure that the data is independent of the observer.
The problem is that the observer ACTS on the data, and the observer and the data get connected.
A simple example. A "law" of economics is that demand falls as the price rises. However, given the "observer" is also a player in the game, the data gets changed: the observer sees housing prices rise (data) so the observer jumps in and buys (player), and prices.....rise, not fall.
Just like Godel's refute of Whitehead and Russell's work, this problem cannot be fixed without making things so severe the work is of no value in key areas.
This is especially true for economics. The economic theories we know and love today are VERY powerful as explanatory tools, but they have no value as predictive tools.
Economic modeling is limited to explaining the past, there is no model that will help us in the future because WE ARE MAKING THE FUTURE; WE ARE NOT JUST OBSERVERS.
We all do this every day subconsciously when we make minor decisions in life. Some more than others. In my opinion, we should focus on it more.
Paul
Lot of investor behavior is irrational that is why we periodically have these fantastic bubbles and then fantastic busts – overshoots on both sides. George Akerlof won the 2001 nobel prize (along with Michael Spence and Joseph E. Stiglitz) for – ‘Analyses of markets with asymmetric information’ – essentially proving that markets are not perfect; contrary to the efficient market and rational investor theory that prevails.
Animal Spirit is difficult to model in a quantified sense, but in the markets we see and talk about the “momentum plays” – these are times when ‘animal spirits’ trump. Prof. Shiller has pioneered this subject of Behavioral Economics, wrote the earlier book “Irrational Exuberance” on the dot com bust.
Another good book on similar subject is ‘Predictably Irrational’ by Dan Ariely.
When you think of it, Efficient Market Hypothesis has reigned for decades while it posited that investment advice, which is a multi-trillion dollar industry, had zero value. Thousands of traders beat the index year in year out, whereas EMH rules this out.
Markets are rational most of the time as negative feedback trading usually prevails. They're just occasionally prone to instances where positive feedback trading (a.k.a. animal spirits) prevails.
Does the dog wag the tail or does the tail wag the dog? Do our brains have the capacity to thoroughly understand the working of the economy? Since awareness is a relative term, I'm not sure we do. We can do our best at least. In some ways economics is a religion: Some truths mixed in with speculation and theories used as an effort (not in vain) to understand a perplexing world.
George Bernard Shaw (1856-1950)
If economists relied less on mathematical models and began to consider the multiple instincts of human nature they'd be correct more often than they now are. Of course, then they couldn't call it a science and would be cast into some category like witchcraft.
A thorough reading of the Economist for over the last twenty years finds little reference to the dangerous growth of leverage or derivatives, the very structures which collapsed so easily last year. For some reason, perhaps because of the mesmerizing mathematics involved, economists did not grasp the fact that Animal Spirits would sooner or later smell the stinking rot within.