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A critical look at standard economic theory.

“The real problem, as we have repeatedly seen in these pages, is the conventional wisdom that underlies so much of current economic theory. So many members of the macroeconomics and finance profession have gone so far in the direction of ‘rational expectations’ and ‘efficient markets’ that they fail to consider the most important dynamics underlying economic crises. Failing to incorporate animal spirits into the model can blind us to the real sources of trouble.” (pg. 167)

Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism levels an attack on current macroeconomic thought: without the incorporation of human psychology into its models, macroeconomics is hopelessly incomplete. While writers of macroeconomic theory have until now relegated the idea of ‘animal spirits’ to the appendixes of textbooks, the authors argue that theorists must give greater prominence to the role it plays within economics.

Penned by George Akerlof (winner of the 2001 Nobel Prize in economics) and Robert Shiller (famed Yale economist and author of Irrational Exuberance and The Subprime Solution), Animal Spirits serves as an authoritative book on the topic of the effect of human psychology on the economy, from two leaders in the field of economics.

The concept of ‘animal spirits’ originated with John Maynard Keynes, who claimed that people fall subject to a range of noneconomic motives when making decisions. These noneconomic motives lead people to make decisions that are not always in their best economic interests; inevitably, this can cause fluctuations in the economy. While at any one point there are a plethora of ‘animal spirits’ at work, the authors highlight five in particular: confidence, fairness, corruption, money illusion, and stories.

Animal Spirits

Confidence: Standard economic theory suggests that when considering investment decisions, managers look to the potential payoff versus the probability of success of each. In reality, it is impossible to know such probabilities; instead, investment is based on how confident managers are in a project’s success. In aggregate, this is shown by the confidence held by all actors about the direction of the economy. The authors then argue that, via a confidence multiplier (similar to the multiplier one uses when examining changes in government spending), changes in confidence can have far reaching impacts on an economy. One gage of confidence can be found below, the Michigan Consumer Sentiment Index (click to enlarge):

Michigan_Index_of_Consumer_Sentiment.JPG

Fairness: The authors argue that fairness, or how ‘fair’ parties see a given transaction, plays a significant role in economic decisions made by individuals, one that is largely ignored by economists. The authors highlight one study in which participants were asked how much they would pay for a beer on a hot day. The same brand of beer was to be brought to them from either a fancy hotel or a run-down supermarket. When using rational economic thought, the person would be willing to pay the same under both circumstances; however, the study found participants would pay 75% more for the beer from the fancy hotel (pg. 22). Fairness prevailed. The authors explain that because one party in a transaction will feel angry if a transaction is unfair, this desire for fairness plays a large role in determining prices.

Corruption: The authors explain how ‘animal spirits’ play a role in promoting antisocial behaviour in economies. They contrast what people need with what people think they need, and they address the role that this plays in fostering corruption. As the authors point out, if people are willing to pay for snake oil (something bad for them), the economy will produce snake oil. This is especially relevant in the financial markets; the authors illustrate how this contributed to the creation of numerous shoddy financial products over the past decade. The authors also note that corruption in financial markets can lead individuals to seek alternative investments. Unsurprisingly, in 2001, investors were turned off of the stock market (after Enron) and sought alternative investments; many turned to invest in housing instead of stocks.

Money Illusion: The authors point out that most decisions are influenced by nominal dollar amounts and not real dollar amounts (those adjusted for inflation). As such, most people “[do not] see through the veil of inflation” (pg. 50). There are numerous instances where money illusion is present in an economy, including: wage contracts that are not adjusted for inflation, legal contracts that are in nominal dollars, debt contracts (the most common type of financial security) that are in nominal terms, and accounting information that is always presented in nominal terms. For example, since most managers’ decisions are based on accounting information, they are subject to money illusion.

Stories: One of the most identifiable ‘animal spirits’ presented is stories. The authors illustrate the role that stories play in the economy; these stories are closely linked to aggregate confidence in an economy. Take, for example, the pervasiveness of ‘New Era’ stories, such as those that surrounded the internet. Stories have a tendency to spread like viruses through populations, and as such one must consider their effect on the economy.

The authors effectively define a number of ‘animal spirits’ that are at work in the economy, and then they go on to show how they can be applied to major problems which face economists. The application of such ‘animal spirits’ to these problems provides a fresh perspective on their causes and potential solutions. One particular chapter tackles the issue of involuntary unemployment; the author goes on to suggest that this occurs partly because of notions of fairness in the labour market exerting upward pressure on wages. Arguably the best chapter in Animal Spirits deals with why financial prices are so volatile. The authors point to the role stories played in the 2000 internet bubble; Merrill Lynch’s advertising message changed from a conservative tone before the bubble, to an aggressive/bullish tone at the bubble’s peak. Unsurprisingly, after the bubble popped, the advertising campaign reverted back to its original conservative tone.

Positives & Negatives

A few caveats must be made with regards to Animal Spirits. First, it was originally written to be used as a textbook in upper year economics courses; accordingly, it skims over many topics, assuming the reader has prior knowledge of economics. Also, as a textbook, it is not the most thrilling read at times; the discussion of the Phillips Curve in the chapter on money illusion is a case-in-point. Finally, despite being published in the midst of the greatest recession in history, Animal Spirits has little to say as to how policy makers can use an understanding of ‘animal spirits’ to alleviate current problems. The chapter that focuses on how to resolve the current crisis is disappointingly standard fare, similar to what can be found in most economics textbooks.

Overall, the book does a fantastic job of laying out what ‘animal spirits’ are, and how they can be used to better understand economics. The authors maintain brevity (the main text is only 176 pages long); short chapters allow the authors to cover a variety of topics, keeping Animal Spirits interesting. As well, the authors tie together their arguments for 'animal spirits' with numerous relevant statistics and academic studies. A great example occurs in the chapter on corruption; the authors suggest that Texas Hold ’em’s displacement of contract bridge as the game of choice in America could arguably be linked to a greater social shift toward an increased acceptance of deception (pg. 40). One could even make the next logical step: that it was this same increased acceptance of deception by society that contributed to banks’ selling questionable financial products over the past decade. Notably, Animal Spirits shines in its chapter on real estate cycles. Situated near the end of the book, after readers are comfortable with notions of ‘animal spirits’, it serves as a culmination and application of all of the relevant concepts presented in the book.

Through reading Animal Spirits, one will walk away with a better understanding of how human psychology plays a major role in the functioning of the economy. It serves as necessary reading for students looking to learn beyond the clean-and-precise models presented in the classroom and looking to understand how the ‘real economy’ works. This is especially necessary for business school students who too frequently put their blind faith in unimpeded free-market capitalism; ‘animal spirits’ make such faith misplaced.

Disclosure: No positions

Source: Book Review: 'Animal Spirits' Offers a Critical Look at Standard Economic Theory