FRIDAY’S WORDS OF WISDOM: ANIMAL SPIRITS BY AKERLOF AND SHILLER

Animal Spirits: How Human Psychology Drives the Economy and Why it Matters for Global Capitalism by George A Akerlof and Robert J Shiller (Princeton University Press, 2010) starts with the argument that traditional economic models based on rational actors and perfect markets cannot explain the economic crisis we currently face and cannot point us in the direction of policies that will solve that problem. At the most basic level, they argue that economic textbooks:

“do not give much enlightenment about the ultimate drivers of the economy. They do not do so because the understanding of drivers must lie somewhat outside the traditional boundaries of economic research, in the realm of psychology… which is an intellectual tradition alien to most economists. Macroeconomists have found it difficult to formalise the concept of animal spirits on their own terms, so they have largely neglected it.” (iii)

They seek to revitalise Keynes’ idea that the economy is driven by more than the rational economic maximisation found in classical economic theory and Adam Smith’s “invisible hand” delivering optimal outcomes. They argue that Keynes’ animal spirits (human psychological factors) have a profound influence the state of the economy. In the view of Keynes:

“the economy is not just governed by rational actors, who ‘as if by an invisible hand’ will engage in any transaction that is to their mutual economic benefit, as the classicists believed. Keynes appreciated that most economic activity is governed by animal spirits. People have noneconomic motives. And they are not always rational in pursuit of their economic interests. In Keynes’ view these animal spirits are the main cause for why the economy fluctuates as it does. They are also the main cause of involuntary unemployment. To understand the economy then is to comprehend how it is driven by the animal spirits. Just as Adam Smith’s invisible hand is the keynote of classical economics, Keynes’ animal spirits are the keynote to a different view of the economy – a view that explains the underlying instabilities of capitalism.” (xxiii)

After the publication of Keynes’ The General Theory those who took up his work – most notably Hicks – set about removing the animal spirits from their interpretation of the work and reducing the differences between Keynes’ vision and the standard classical economic models of the day in which people only acted rationally. This watering down of Keynes’ work left it vulnerable to Friedman and the “New Classical Economics” that argued that the remaining differences between Keynesianism and the rational actor model were too insignificant to make any difference. The distinctive elements of Keynesian economics were laid aside and the idea of the invisible hand in free markets was re-established. But the crises in the global economy cannot be explained by the reductive models of the classical and neo-classical economic theorists.

“To understand how economies work and how we can manage them and prosper, we must pay attention to the thoughts patterns that animate people’s ideas and feelings, their animal spirits. We will never really understand important economic events unless we confront the fact that their causes are largely mental in nature… economists and business writers apparently do not seem to appreciate this… They assume that variations in individual feelings, impressions, and passion do not matter in the aggregate and that economic events are driven by inscrutable technical factors or erratic government action. In fact… the origins of these events are quite familiar and are found in our everyday thinking. (1)

Current economic thinking seeks to build models that minimise, as much as possible, departures from pure economic motivations – they seek to preserve the elegance of the pure, mathematical models around which much of the economics profession is built.

“There is a good reason for doing so… The economics of Adam Smith is well understood. Explanations in terms of small deviations from Smith’s ideal system are thus clear, because they are posed with in a framework that is already well understood. But that does not mean that these small deviations from Smith’s system describe how the economy really works… In our view economic theory should be derived not from minimal deviations from the system of Adam Smith but rather from the deviations that actually do occur and that can be observed. Insofar as animal spirits exist in the everyday economy, a description of how the economy really works must consider those animal spirits.” (5)

The book describes:

“five different aspects of animal spirits and how they affect economic decisions – confidence, fairness, corruption and antisocial behaviour, money illusion and stories:

  • The cornerstone of our theory is confidence and the feedback mechanisms between it and the economy that amplify disturbances.
  • The setting of wages and prices depends largely on concerns about fairness.
  • We acknowledge the temptation towards corrupt and antisocial behaviour and their role in the economy.
  • Money illusion is another cornerstone of our theory. The public is confused by inflation or deflation and does not reason through its effects.
  • Finally, our sens of reality, of who we are and what we are doing is intertwined with the story of our lives and of the lives of others. The aggregate of such stories is a national or interneational story which itself plays an important role in the economy.” (5-6)

Confidence and its multipliers

Confidence is used in economics generally to refer to a prediction between a number of possible equilibria, for example, whether the economy will improve and, therefore, it makes sense to invest or to whether it will decline and therefore it doesn’t. “A confident prediction is one that projects the future to be rosy; an unconfident prediction is one that projects the future to be bleak.” (12)

But Akerlof and Shiller have a different view of confidence, tying it to trust.

“Economists have only partly captured what is meant by trust or belief. Their view suggests that confidence is rational: people use the information at hand to make rational predictions; they then make rational decisions based on those rational predictions. Certainly people often do make decisions, confidently, in this way. But there is more to the notion of confidence. The very meaning of trust is that we go beyond the rational. Indeed the truly trusting person often discards or discounts certain information. She may not even process the information that is available to her rationally; even if she has processed it rationally, she still may not act on it rationally. She acts according to what she trusts to be true.” (12)

Using confidence in this sense reveals why it plays a major role in the business cycle.

“In good times people trust they make decision spontaneously. They know instinctively that they will be successful. They suspend their suspicions. Asset values will be high and perhaps also increasing. As long as people remain trusting, their impulsiveness will not be evident. But then, when confidence disappears, the tide goes out. The nakedness of their decisions stands revealed.” (13)

The very term confidence implies behaviour that is not wholly rational – and economic history is full of cycles of buying and withdrawal based on fluctuations of people’s confidence in certain commodities or markets. For Keynes, this was obvious but:

“Standard economic theory suggests otherwise. It describes a formal process for making rational decisions: People consider all the options available to them. They consider the outcomes of all these options and how advantageous each outcome would be… But can we really do that? Do we really have a way to define what those probabilities and outcomes are? Or, on the contrary, are not business decisions – even many of our own personal decisions about which assts to buy and hold – made much more on the basis of whether we have confidence? … Many of the decisions we make – including some of the most important ones in our lives – are made because they “feel right”. (13-14)

Confidence has wider implications than what it means for the decisions taken by individuals. Akerlof and Shiller explore the idea of a confidence multiplier.

“That represents the change in income from a one-unit change in confidence – however it might be conceived or measured. We can also think of the confidence multiplier, like the consumption multiplier, as resulting from different rounds of expenditure. Here the feedbacks are more interesting … Changes in confidence will result in changes in income and confidence in the next round, and each of these changes will in turn affect income and confidence in yet further rounds… We conceive of the link between changes in confidence and changes in income as being especially large and critical when economies are going into a downturn, but not so important at other times” (16-17)

 

Fairness

Akerlof and Shiller survey some of the studies that demonstrate that people have an innate sense of fairness in their economic dealings and  that this can have a significant impact on the decisions they make. The influence of fairness cannot be accounted for by the rational actor models of economics. Notions of fairness are, in practice, a key motivation for people when making economic decisions yet they are marginalised in economic theory and teaching.

“Economic textbooks are supposed to be about economics, not about psychology, anthropology, sociology, philosophy, or whatever branch of knowledge teaches us about fairness. Those who assign the economics textbooks want to teach their special expertise. Pure economic theory is indisputably valuable in a wide range of applications, and so there is a natural tendency to focus on that magnificent theory – even if it doesn’t fit some other very important applications. Focusing exclusively on the rational theory leads to an elegant presentation. It would violate the etiquette of textbooks to mention that some other factor, outside the formal discipline of economics, is the fundamental cause of certain major economic phenomena. It would be like burping loudly at a fancy dinner.” (21)

The evidence in studies by economists like Kahneman, Ketsch and Thaler demonstrate that people apply standards other than straightforward rational analysis to their economic choices. Akerlof and Shiller look at ideas of fairness developed in sociology, which include notions of status and societal norms and conclude: “Fairness then involves brining into economics those concepts of how people think they and others should or should not behave.” (25)

 

Corruption and Bad Faith

To understand the economy we must  understand its:

“sinister side – the tendencies toward antisocial behaviour and the crashes and failures that disrupt it at long intervals or in hidden places. Some economic fluctuations may be traced to changes over time in the prominence, and the acceptability, of outright corruption. Even more significantly, there are changes over time in the prevalence of bad faith – economic activity that while, technically legal, has sinister motives.” (26)

Capitalism doesn’t automatically produce what people need, it produces what they think they need and are willing to pay for and that, therefore, makes the production of “snake oil” profitable. For the most part consumers are knowledgeable enough to avoid such traps or to avoid repeat purchases if they are fooled once, but there remains a requirement of governments to provide consumer protection. Akerlof and Shiller argue this is particularly true in financial markets where people invest their savings for the future – especially in stocks, bonds, pensions and insurance.

“The physical nature of these assets testifies to their insubstantiality: they are no more than pieces of paper, representing implicit promises of future payments. There is something inherently unknowable about the worth of most of these sources of savings in the modern economy. Because of economies of scale, capitalist enterprises have grown immensely large and complex.” (27)

That leave investors open to exploitation in the financial markets – and fraud and corruption in this area can have devastating effects. “Each of the past three economic contractions in the United States… involved corruption scandals. Scandals played a role in determining the severity of each of these recessions” (29) and this illustrates that the business cycle is connected to variations in the levels of personal commitment to principles of good behaviour and levels of predatory activity in the economy.

“Culture changes over time to facilitate or hinder aggressively competitive and predatory activities. Because these cultural changes are difficult to quantify, and fall outside the field of economics, they are rarely connected by economists to economic fluctuations. They should be.”

 

Money Illusion

Modern economic theory assumes that people account for every element of a transaction when they are making an economic choice. But the money illusion – especially when related to inflation, which people rarely account for in their contracts or wage negotiations – demonstrates that this is not the case.

“Money illusion occurs when decisions are influenced by nominal dollar amounts. Economists believe that if people were ‘rational’ their decisions would be influenced only by what they could buy or sell in the marketplace with those nominal dollars. In the absence of money illusion, pricing and wage decisions are influenced only by relative costs or relative prices, not by the nominal value of those costs or prices.” (41)

When economic textbooks introduce money they describe it as “a medium of exchange, a store of value, and a unit of account… But economists have paid scant attention to the role of money as a unit of account.” (47) As a unit of account, people think in terms of money’s numerical value not in what that money can be exchanged for or what it is actually worth. Accounting, contracts, tax legislation all use the money as a unit not its actual value or what it is buys in exchange. People could adjust their contracts and negotiations to allow for the fact that inflation alters the value of the nominal monetary unit – but Akerlof and Shiller demonstrate that this often not the case.

“We have seen that one of the most important assumptions of modern macroeconomics is that people see through the veil of inflation. That seems to be an extreme assumption. It also seems totally implausible given the nature of wage contracts, of price setting, of bond contracts, and of accounting. These contracts could easily throw aside the veil of inflation through indexation. Yet the parties to the contracts in most cases choose not to. And these are but a few indicatison of money illusion… Once again animal spirits play a role in how the economy works.” (50)

 

Stories

Narrative play a key part in the working of the human mind – allowing us to sequence events around an internal logic that appears to give our lives a unified nature and that, in turn, provides us with many of our motivating urges. Stories are so important that research demonstrates that we struggle to hold on to memories we can’t fit into narrative structures and that we don’t repeatedly tell to others and, as Nasim Taleb demonstrates in Fooled by Randomness, our reliance on stories makes it difficult for the human brain to comprehend the world, and all its random occurrences, as it truly is.

Economists tend to avoid basing their analysis on stories – it is unprofessional to use anecdote rather than quantitative analysis.

“But what if the stories themselves move markets? … What if they themselves are a real part of how the economy functions? Then economists have gone overboard. The stories no longer merely explain the facts; they are the facts.” (54)

Stories play a key role in developing confidence – especially the common notion of a new era, in which historic changes are supposed to propel the economy into an entirely different state where old rules and certainties no longer apply.

“Confidence is not just the emotional state of an individual. It is a view of other people’s confidence, and of other people’s perceptions of other people’s confidence. It is also a view of the world – a popular model of current events, a public understanding of the mechanism of economic change as informed by the news media and by popular discussions. High confidence tends to be associated with inspirational stories, stories about new business initiatives, tales of how others are getting rich. New era stories have tended to accompany the major booms in stock markets around the world. The economic confidence of past times cannot be understood without reference t the details of these stories.” (55)

 

Economic questions

Akerlof and Shiller then ask eight questions

  1. Why do economies fall into depression?
  2. Why do central bankers have power over the economy, insofar as they do?
  3. Why are there people who can’t find a job?
  4. Why is there a trade-off between inflation and unemployment in the long run?
  5. Why is saving for the future so arbitrary?
  6. Why are financial prices and corporate investments so volatile?
  7. Why do real estate markets go through cycles?
  8. Why does poverty persist for generations among disadvantaged minorities?

In response to each question they “see that animal spirits provide an easy answer to each of the questions. We also see that, correspondingly, none of these questions can be answered if people are viewed as having only economic motivations which they pursue rationally – that is, if the economy is seen as operating according to the invisible hand of Adam Smith.” (6)

 

Conclusion

The real problem, according to Akerlof and Shiller, is that the conventional wisdom that underlies so much of current economic theory failst to see the world as it really is, preferring instead to treat rely on their elegantly constructed, but simplified, models. So many members of the macroeconomics and financial profession have gone so far in the direction of ‘rational expectations’ and ‘efficient markets’ that they fail to allow for human nature and for the animal spirits that direct people’s real decisions. They:

“exclude the changing thought patterns and modes of doing business that bring on a crisis. They even exclude the loss of trust and confidence. They exclude the sense of fairness that inhibits the wage and price flexibility that could possibly stabilize the economy. They exclude the role of corruption and the sale of bad products in booms, and the role of their revelations when the bubbles burst. All of these exclusions from conventional explanations of how the economy behaves were responsible for the suspension of disbelief that led up to the current crisis. They are also responsible for our current failure in knowing how to deal with the crisis now that it has come.” (167)

To understand how the economy really works, and how to respond to the crisis, theories need to include the reality of animal spirits and their influence on individual and collective economic decisions. Akerlof and Shiller imagine a square divided into four boxes denoting economic and non-economic motives and rational and non rational responses.

“The current model fills only the upper left-hand box; it answers the question: How does the economy behave if people only have economic motives, and if they respond to them rationally. But that leads immediately to three more question, corresponding to the three blank boxes: How does the economy behave with noneconomic motives and rational responses? With economic motives and irrational responses? With non-economic motives and irrational responses. We believe that the answers to the most important questions regarding how the macroeconomy behaves and what we ought to do when it misbehaves lie largely (though not exclusively) within those three blank boxes.” (168)

Akerlof and Shiller believe that market capitalism has been, and continues to be, a successful means of organising our societies. This is not really a crisis of capitalism but merely a moment in which we must recognise that capitalism requires rules to protect us from the animal spirits that distort our economy. Government must have a role.

“Such a world of animal spririts gives the government an opportunity to step in. Its role is to set the conditions in which our animal spirits can be harnessed creatively to serve the greater good. Government must set the rules of the game. There is then, a fundamental reason why we differ from those who think that the economy should just be a free-for-all, that the least government is the best government, and that the government should play only the most minimal role in setting the rules. We differ because we have a different vision of the economy. Indeed if we thought that people were totally rational, and that they acted almost entirely out of economic motives we too would believe that government should play little role in the regulation of financial market, and perhaps even in determining the level of aggregate demand. But, on the contrary, all of those animal spirits tend to drive the economy sometimes one way and sometimes another. Without intervention by government the economy will suffer massive swings in employment. And financial markets will, from time to time, fall into chaos.” (173)

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