“Animal Spirits” by Akerlof and Shiller

In a Nutshell

Akerlof and Shiller argue that traditional macroeconomic theory has lost its way by making it more scientific, with the result that it only addresses a small part of the observed macroeconomic behavior because it only focuses on rational and economic drivers. ‘Animal spirits’ (irrational or non-economic motives) introduced (concepts introduced by) Keynes during the depression, were forgotten with elapsed time since the depression. Yet they are the required to explain the mis-behavior of macro-economics.

These ‘animal spirits’, which according to the authors drive the economy, are represented by five psychological factors: (1) confidence, (2) fairness, (3) corruption and bad faith, (4) money illusion and (5) stories. According to the authors the invisible hand of the free markets is a powerful construct, but capitalism doesn’t police itself. Regulations and enforcements are essential, just like in a “serious team sport: there have to be rules and there has to be a referee who enforces them”. However, over the past 30 years the value and importance of regulations appears to have been forgotten and alongside with it forgetting about “the soft underbelly of capitalism”.  This book is built on the (relatively) new field of behavioral economics which attempts to explain how (unlike outcomes in physics which are largely predictable since it deals with ‘things’) how the economy really works given that “people ale are really human” and are driven by ‘animal spirits’ (and unpredictable).

The details

The authors describe ‘animal spirits’ as:

“Confidence and the feedback mechanism between it and the economy that amplify disturbances” (Despite what classical economics might teach us, investment decision depend on confidence and the confidence multiplierwhich by means of feedback amplifies the effect of small negative/positive stimuli)

“The setting of wages and prices depends largely on concerns about fairness” (“Fairness …involves bringing into economics these concepts of hoe people think they and others should or should not behave.)

“We acknowledge the temptation toward corrupt and antisocial behavior and their role in the economy” (Capitalism produces not what people need but whatever people will pay for, are willing to pay for and can be produced at a profit; that includes snake oil! The authors believe especially strongly that “there is one field in which consumer protection is especially needed, and in which is especially difficult to provide. This is in the area of securities, which represent people’s savings for the future. They also conclude that “the business cycle is connected to fluctuations in personal commitment to principles of good behavior and to fluctuations in (opportunities for) predatory activity.”)

Money illusionmeans that “the public is confused by inflation or deflation and does not reason through its effects” (If fact they demonstrate via wage contracts, price setting, bond contracts and accounting that the assumption that people see through the veil of inflation/deflation is an extreme assumption.)

“Our sense of reality, of who we are and what we are doing, is intertwined with the story of our lives and the lives of others. The aggregate of such stories is a national or international story, which itself plays an important role in the economy” (The authors suggest that often “the stories no longer merely explain the facts; they arethe facts.” Stories spread by word of mouth” like diseases (viruses)” spread through contagion”. Epidemics of confidence or epidemics of pessimism may arise mysteriously simply because there was a change in the contagion rate of certain modes of thinking.”

The second half of the book addresses eight questions:

“Why do economies fall into depression?”  (All elements of ‘animal spirits come into play.)

“Why do central bankers have power over the economy?” (Key element is confidence.)

“Why are there people who cannot find a job?” (Human demand for fairness explains unemployment.)

“Why is there a trade-off between inflation and unemployment in the long run? (The “interaction between money illusion and fairness makes a difference”)

“Why is saving for the future so arbitrary? (People have difficulty in visualizing themselves in the distant future. People also have difficulty understanding that becoming rich is not about an invention, an investment might pay off 1000x, and other “flukes of luck”; almost anyone can become moderately rich by saving a lot of money. Saving or consuming is framed by the “stories we tell about our lives and our future”. Cues to saving (i.e. framing) are powerful tools to affect savings rates: “save more tomorrow”, “auto-enrolment’ to saving plans, employers/governments subsidize pension contributions.)

“Why are financial prices and corporate investments so volatile? (Not only are major market price moves unpredictable, but they are also frequently unexplainable rationally even in retrospect. Confidence multiplier (feedback) can create bubbles or crashes. Business (e.g. investment) decisions are made in the face of uncertainty; according to Knight, risk is something that can be measured by probabilities, however there are no objective standards for uncertainty so it cannot be measured.)

“Why do real estate markets go through cycles? (As you can imagine the recent real estate boom was also driven by animal spirits like confidence, corruption, money illusion and storytelling.)

“Why is there special poverty among minorities? (Explanations revolve around stories)

The bottom line

To really understand the workings of the economy, classical macroeconomics (with its ‘rational expectation’ and ‘efficient markets’) must be extended to include  ‘animal spirits’  to explain the irrational and non-economic motives of humans.

“Capitalism can give us the best of all possible worlds, but it does so only on a playing field where the government sets the rules and acts as referee. Unconstrained capitalism is especially dangerous in financial markets, where it can result in excesses. Government regulations must act also to dampen the wild swings that that would otherwise occur and to prevent the sale of ‘snake oil’ in the financial markets.”