stumblingandmumbling.typepad.com February 26, 2009
Animal Spirits: A review Alex Curran, Stevie Gerrard's missus, _has said_ (http://www.thespoiler.co.uk/index.php/2009/02/10/recession-threatens-alex-currans-bikini-wearing-abili ty) that the recession is causing her to cut her spending. To orthodox economics with its rational maximizing people, this makes no sense. The downturn isn’t hitting Stevie G’s earning power or permanent income, so why should it reduce her spending? It’s in this context that George Akerlof and Robert Shiller’s new book, _Animal Spirits_ (http://www.amazon.co.uk/Animal-Spirits-Psychology-Economy-Capitalism/dp/0691142335) , comes to the rescue. We cannot, they say, understand major economic events without paying attention to “the thought patterns that animate people’s ideas and feelings, their animal spirits.” These spirits, they say, comprise five different aspects: confidence, fairness, corruption, money illusion, and stories. These aspects can generate booms and slumps. I suspect three of these lie behind Ms Curran’s cutbacks. Though the recession is not materially hitting her, it’s sapping her confidence; she’s telling a story in which the recession means that people are becoming more frugal; and she might think it unfair to go on spending sprees when others cannot. Through these routes, the recession is bigger than it would otherwise be, because Ms Curran - and millions like her - cut their spending too. Akerlof and Shiller explain how the other two fit into booms and slumps. In booms, confidence is high. People trust each other and get greedy for high returns. So Madoff and Stanford thrive. Money illusion matters too. It causes people to over-estimate long-run returns on house prices - thus contributing to the boom in them. And as it causes workers to resist nominal pay cuts, downturns in demand lead to big falls in employment. All of this is overlooked by orthodox economics with its rational utility maximizes. Akerlof and Shiller are too polite to say so, but I suspect the emphasis put upon the max U story in universities is in part due not to its factual accuracy - though as Akerlof and Shiller concede this is not wholly lacking - but to the fact that it generates nice mathematical exam questions. So, how well does their story fill the gap? No doubt, you can’t understand the housing market or capital spending decisions without animal spirits. In this sense, they score big hits. But I fear they are stretching a little in trying to apply their story to minority poverty. And I’m not sure animal spirits - in the sense of pure irrationality - is the whole story behind stock market volatility; I’d have welcomed a discussion of Patrick Minford’s _idea_ (http://ideas.repec.org/p/cdf/wpaper/2006-13.html) that small changes in the probability of disaster or boom can rationally generate high volatility. I’d also have welcomed more on how exactly the “confidence multiplier” works. Yes, confidence raises asset prices which in turn raise investment. But how is it that sometimes confidence leaps from one person to another - causing big booms - and sometimes it doesn’t, with the result that we get economic stability? There’s a single line of how stories can spread like epidemics, but no discussion of, for example, Christopher Carroll’s work on the _epidemiology_ (http://ideas.repec.org/p/jhu/papers/462.html) of expectations. There are a couple of other gaps that might have strengthened their argument. There’s no mention of work in neuroeconomics (survey pdfs _here_ (http://www.lrz-muenchen.de/~u516262/webserver/webdata/bernheim2008_neuroecon_nberw p.pdf) and _here_ (http://www.hss.caltech.edu/~camerer/JELfinal.pdf) ) by the likes of _Drazen Prelec_ (http://www.scienzesociali.ailun.it/so/docenti/prelec.shtml) or _Colin Camerer_ (http://www.hss.caltech.edu/~camerer/camerer.html) , even though this is perhaps undermining the notion of a single, united rational self. An even bigger gap is the lack of any discussion of _Austrian_ (http://www.econlib.org/library/Enc/AustrianSchoolofEconomics.html) economics. As it stands, Animal Spirits contrasts rational _homo economicus_ (http://en.wikipedia.org/wiki/Homo_economicus) with skittish irrational Alex Currans. But the Austrians give us a third way. The facts necessary for rational calculation are often missing or unknowable; as_ G.L.S Shackle _ (http://mises.org/journals/aen/shackle.asp) said, knowledge of the future is a contradiction in terms, and - I‘d add - bosses rarely know workers‘ marginal products. In conditions of such unavoidable ignorance, animal spirits are all we have to motivate economic actions. It’s not that people are irrational - it’s that they just haven’t the tools to be rational with. Which leads me to another issue; is the ubiquity of animal spirits really a bad thing? Maybe not. Daniel Gross has _shown_ (http://www.amazon.co.uk/Pop-Why-Bubbles-Great-Economy/dp/0061151548) that bubbles leave a benign legacy; those condos in Miami may be worth only a fraction of what they cost, but they put roofs over folks’ heads. And Robert Lucas has _shown (pdf)_ (http://home.uchicago.edu/~sogrodow/homepage/paddress03.pdf) that the average costs of economic fluctuations are small and can in principle in shared by using better markets in risk - which Shiller’s own superb _work_ (http://newfinancialorder.com/) has helped demonstrate. What’s more, given that the private benefits of innovation are _low_ (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=537242) , and the probabilities of success in many arts and industry small, it might be only animal spirits that give us artists and entrepreneurs. As Richard Nisbett and Less Ross _wrote_ (https://www.alibris.co.uk/search/books/qwork/3045080/used/Human%20Inference:%20Strategies%20&%20Shortcomings%20of%20Social%20Judgement) years ago: We probably would have few novelists, actors or scientists if all potential aspirants to these careers took action based on a normatively justifiable probability of success. We might also have few new products, new medical procedures, new political movements or new scientific theories. Perhaps, then, it’s not just that animal spirits are ubiquitous - but they are necessary too. February 26, 2009
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