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.