naked capitalism

Submitted by DoctoRx, who comments on the economic and financial scenes at EconBlog Review:

In thinking about Animal Spirits, I am reminded of Spencer Tracy’s comment about Katharine Hepburn in Pat and Mike: “Not much meat on her, but what’s there is cherce.” There’s not much meat on the bones of Animal Spirits, and what’s there is not so choice.

Drs. Akerlof and Shiller argue that modern economics has lost its way by ignoring the psychological aspects of economic behavior. They refer to Keynes’ mention in his General Theory (1936) of the need for “animal spirits” to arise, and therefore engender risk taking to lead the economy out of Depression. The authors adapt the “animal spirits” term to their own broader use, explaining the subtitle: How Psychology Drives the Economy, and Why It Matters for Global Capitalism.

Reviewing and decrying the history of economics morphing into a “science” related to mathematics, they make the sweeping statement:

In our view economic theory should be derived not from the minimal deviations from the system of Adam Smith but rather from the deviations that actually 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 these animal spirits. This is the aim of the book.

They continue

In producing such a description, we think that we can explain how the economy works. This is a subject of permanent interest. But, writing as we are in the winter of 2008-9, this book also describes how we got into the current mess- and what we need to do to get out of it.

They really are saying that a proper theory of how economies work should be derived in toto from exceptions to Adam Smith’s system. Unfortunately, they do not demonstrate how they intend to prove this big point to their academic confreres.

The book lays out five categories of animal spirits, with the authors’ explanatory quotes where appropriate:

1. “The cornerstone of our theory is confidence and the feedback mechanisms between it and the economy that amplify disturbances;”

2. “The setting of wages and prices depends largely on concerns about fairness;”

3. “Corruption and antisocial behavior” and the perception of the existence and pervasiveness of such.

4. “Money illusion is another cornerstone of our theory. The public is confused by inflation and deflation and does not reason through its effects;”

5. “Stories”- perhaps a catchall for themes, culture, and big picture stuff as people perceive it.

DoctoRx here. Surely modern economists are aware of money illusion, as they are that confidence or lack of such affects all sorts of economic variables. Can an entire new theory of economics really be derived from these variables? What predictive rather than post hoc value, would they have? The Governor of a State who wants to know if raising a sales tax from 5% to 6% would generate much additional revenue is likely well served by existing formulae derived from observations plus evolving theory. How would he/she take into effect any perception by the State’s residents that he/she for example is/is not corrupt or that the people’s mood is sour or ebullient?

In my very humble opinion, these five categories are interesting but don’t add nearly as much information to economics as the authors say they do.

After discussing the above five categories, the authors list eight major economic decisions and boldly assert:

We see that animal spirits provide an easy answer to each of these questions. (Emph. added)

Here is where they began to truly lose me. Any time anyone, even a Nobel Prize winner and a superstar, says there is an easy answer to complex problems, and tells the public of this easy answer before convincing their academic colleagues, one should be on guard. Sadly, this statement reminds me of the latest over-the-counter miracle cure for some ailment or for multiple ailments. Akerlof and Shiller go on to say:

In answering these questions, in telling how the economy really works, we accomplish what existing economic theory has not.

The above statement is so sweeping that it was immensely disappointing to fail to find persuasive arguments to support it. Argument by anecdote and implication is inadequate to the heavy task they set themselves.

The eight questions include why there is not full employment, why do central bankers have power over the economy, why do depressions occur, why is there special poverty among minorities, among others.

Moving on to current events, the authors say that “the crisis was not foreseen . . . because there have been no principles in conventional economic theories regarding animal spirits”.

I have to disagree both that the crisis was not foreseen and that known principles could not have predicted/explained it.
On the first point, Nassim Taleb predicted there would be a major crisis when he saw the balance sheets of Fannie Mae and Freddie Mac several years ago. He just did not know when all the leverage would blow them up. He makes clear that in his view, this crisis was NOT a black swan event. Similarly, Nouriel Roubini grasped from his experience with emerging market currency, financial and economic crises that this mess was brewing. Either Dr. Roubini was tremendously lucky, or he was clearly on to something when in the winter of 2008 he laid out a set of predictions for the crisis that more or less all came true. What happened with the freeze-up of credit did not stem from irrational behavior and does not need a new theory of economics based on behavior psychology to explain it pre-or post-event. After the events involving Fannie and Freddie, then especially Lehman and AIG, counterparty risk was real and major. Reluctance to lend was rational, no matter how much Drs. Shiller and Akerlof argue otherwise. Reluctance to lend remains rational due to declining credit quality; the authors state that this reluctance needs behavioral psychology to explain it.

What new theories are required to understand that excessive and poor lending practices can blow up?

The authors say that the current mess could not have happened for rational, predictable reasons. Many disagree. It can be asserted that the individuals in the financial community acted rationally, maximizing their individual wealth. In January of 2008, a stock broker told me that bankers always take excessive chances, knowing that the Fed or Government (nowadays one and the same for all practical purposes) will bail them out of their mistakes. Homebuyers thought they were rational. They “knew” that house prices always trend up. Leveraged borrowers were rational if they were playing with Other People’s Money; heads I win and you do OK, tails you lose and I neither win nor lose (or win less than if heads came up).

The book asserts:

We provide a theory that explains fully and naturally how the U. S. economy, and indeed the world economy, has fallen into the current crisis. And- of perhaps ever greater interest- such a theory allows us to understand what needs to be done to extricate ourselves from the crisis.

Again I beg to differ.

From a policy standpoint, the actions taken by Presidents Bush and Obama, Fed Chairman Bernanke, Congress, etc., are conventional policies that required no new theories of animal spirits to be thought of or to be implemented. Akerlof and Shiller simply support what’s been done. They propose no new programs or domestic psych-op campaigns to bring behavioral economics insights to bear to turn the economic tide. These facts severely undercut their assertions quoted above.

The authors also have a political agenda that confuses the reader who wants to focus on their core theories. Dr. Akerlof is married to Janet Yellen, a Democratic stalwart and currently head of the San Francisco Federal Reserve Bank. One can hear the contempt drip when they mention Reaganism and Thatcherism only with regard to deregulation; they ignore the fact that Jimmy Carter began the deregulatory movement. The authors both overstate the importance of monetarism in U. S. policy since 1981 and appear to blame its use on Republicans. It was actually a Democrat, Paul Volcker, who implemented monetarism when he ran the Fed; Ronald Reagan was a Keynesian. Keynesians have served as President and have run Congress for years, Republican and Democrat alike. You would not know this from the book.

Again bringing politics into the book, the authors go farther than the facts allow in arguing for full employment. They say:

This had been the vision in previous generations of those who established central banks: the role of central banks is to insure the credit conditions that enable full employment.

This would be news to those who made the Bank of England the central bank, rather than just any old bank. In what were the monarchs of 17th and 18th Century England really interested? European and world domination, yes; marvelous living conditions for the populace, hardly. It would also be news to the New York Fed, whose Web site states that the Federal Reserve Act “provided for the establishment of Federal Reserve Banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”

Moreover, the U. S. Fed of course has a dual mandate of balancing full employment with inflation considerations. The European Central Bank has a single mandate, dealing with inflation alone rather than full employment; the feeling in Europe was that unemployment considerations should be dealt with by elected governments, not central bankers.

Finally, the authors state flatly that an important part of their theory if implemented would be that the government would be analogous to a parent who should “set the limits so that the child does not overindulge her animal spirits”. This becomes circular: who regulates the regulator; who protects the Fed Chairman from irrational exuberance? What happens when the Government gets it wrong, but the people get it right? The parent-child analogy is more than a bit condescending.

SUMMARY: Animal Spirits repeatedly fails to prove or even strongly support its major, overly broad theses, and veers off at times into unnecessary and poorly-supported partisan political rhetoric. The book would read better if the authors had checked their political agenda at the door. I was left with the unpleasant feeling that this book was written more for mercenary and political reasons than academic ones.