Economists, in pursuit of mathematical precision, seem to have forgotten that not everything can be easily counted. Traditional economic theory centers on the premise that people make perfectly rational decisions. People, however, are not so rational. Despite many attempts, not every variable that goes into our decision-making process can be easily quantified, weighted, and stuffed into a formula. As any non-economist knows psychology -- and its hard to measure variables -- plays a large role in how people make decisions.
George Akerlof and Robert Shiller’s book, Animal Spirits, offers an accessible look at how traditional economics can be expanded by incorporating some basic concepts from psychology. The term “animal spirits,” originally coined John Maynard Keynes in the 1930’s, describes how impulses and emotions naturally lead to economic boom and bust cycles. Traditional economists seem to have ignored even the most primitive of these spirits.
Economists create impressively complex formulas attempting to accurately describe the state of the economy and predict future trends. However, there are just too many unquantifiable variables – feelings, emotions, intuition, and confidence– to accurately incorporate all available information into a simple neat equation. Incorporating psychology into economics may not sound like much of a breakthrough. But Akerlof and Shiller have stepped outside of current economic thought to gently nudge animal spirits back to the discipline.
The first part of the book offers five examples of animal spirits: confidence; corruption; money illusion; stories; and fairness. While there are many more psychological factors at work in decisions, these offer a step in the right direction. A quick look at the internet bubble shows how these spirits can unknowingly influence our decisions.
In the late 1990’s, investors were confident in a “new economy” and drove the price of internet related stocks up far more than a reasonable estimation of their economic prospects would justify. As the stock market increased in value, we entered a positive-feedback cycle from our investment decisions that further increased our confidence. As confidence rose so did the markets. In the end, we all know how this cycle turned out.
In the second part of the book Akerlof and Shiller answer some big questions calling attention to the role of the animal spirits. Why do economies fall into depression? Why is saving for the future so arbitrary? Why is there unemployment? Why are financial prices so volatile? Why do real estate markets go through cycles? Why is there special poverty amongst minorities?
The book offers persuasive, well-researched, prose that challenges the conventional wisdom that underlines much of existing economic theory. In attempting to answer some large fundamental economic questions by calling attention to psychological influences, the book offers a first glimpse of what economic solutions might look like in the future.
Overall rating: 4/5 stars.
This book is available from Princeton University Press.