Animal Spirits

How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism

George A. Akerlof, Robert J. Shiller

• Publisher: Princeton University Press
• Year: 2010
• ISBN:
  9781400834723
• Topic: Business
• Subtopic: Business General
• Index: Business

From acclaimed economists George Akerlof and Robert Shiller, the case for why government is needed to restore confidence in the economy The global financial crisis has made it painfully clear that powerful psychological forces are imperiling the wealth of nations today. From blind faith in ever-rising housing prices to plummeting confidence in capital markets, "animal spirits" are driving financial events worldwide. In this book, acclaimed economists George Akerlof and Robert Shiller challenge the economic wisdom that got us into this mess, and put forward a bold new vision that will transform economics and restore prosperity.Akerlof and Shiller reassert the necessity of an active government role in economic policymaking by recovering the idea of animal spirits, a term John Maynard Keynes used to describe the gloom and despondence that led to the Great Depression and the changing psychology that accompanied recovery. Like Keynes, Akerlof and Shiller know that managing these animal spirits requires the steady hand of government—simply allowing markets to work won't do it. In rebuilding the case for a more robust, behaviorally informed Keynesianism, they detail the most pervasive effects of animal spirits in contemporary economic life—such as confidence, fear, bad faith, corruption, a concern for fairness, and the stories we tell ourselves about our economic fortunes—and show how Reaganomics, Thatcherism, and the rational expectations revolution failed to account for them. Animal Spirits offers a road map for reversing the financial misfortunes besetting us today. Read it and learn how leaders can channel animal spirits—the powerful forces of human psychology that are afoot in the world economy today. In a new preface, they describe why our economic troubles may linger for some time—unless we are prepared to take further, decisive action.

Part One

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Animal Spirits

ONE

Confidence and Its Multipliers

ONE OF US (Akerlof) remembers a dinner conversation a few years ago. During the housing boom a distant relative from Norway—by marriage by marriage by marriage, known only from a brief encounter at a family wedding—had reportedly bought a house in Trondheim, for more than $1 million. That seemed like a lot of money—perhaps not for New York, Tokyo, London, San Francisco, Berlin, or even for Oslo—but certainly for Trondheim, up the Norwegian coast, on the edge of settlement, and vying for the title of world’s most northern city. Nor was it a mansion. This thought remained quietly parked in Akerlof’s brain, classified along with other observations that property values were high in Scandinavia.

Recently Akerlof told his co-author, Shiller, that he had been wondering if he should have given more thought to the Trondheim story. We discussed the matter. This seems to have been a mental lapse, accepting this story of the high price as nothing more than an insignificant oddity. On the contrary, Akerlof should have seen it as an incongruity requiring active thought, to be resolved within the context of a larger view of the markets.

We decided that this little story is worth pondering at greater length—for the insight it offers into the thought patterns that underlie the booms and busts that characterize the business cycle, and, notably, the twin crises of confidence and credit that currently envelop much of the world.

Confidence

The newspapers and the pundits tell us when the economy goes into recession that it is necessary to “restore confidence.” This was J. P. Morgan’s intention after the stock market crash of 1902 when he put together a bankers’ pool to invest in the stock market. He employed the same strategy in 1907.¹ Franklin Roosevelt analyzed the Great Depression in similar terms. “The only thing we have to fear,” he declared in his first inaugural address in 1933, “is fear itself.” Later in the same speech he added: “We are stricken by no plague of locusts.” Ever since the founding of the U.S. republic, business downturns have been proclaimed as the result of a loss of confidence.

Economists have a particular interpretation of the meaning of the term confidence. Many phenomena are characterized by two (or possibly more) equilibria. For example, if no one rebuilds his house in New Orleans after Hurricane Katrina, no one else will want to rebuild. Who would want to live in desolation, with no neighbors and no stores? But if many people rebuild in New Orleans, others will also want to. Thus there may be a good—rebuilding—equilibrium, in which case we say that there is confidence. And there may also be a bad—non-rebuilding —equilibrium, with no confidence. In this view there is nothing more to confidence than a prediction, in this case regarding whether or not others build. A confident prediction is one that projects the future to be rosy; an unconfident prediction projects the future as bleak.

But if we look up confidence in the dictionary, we see that it is more than a prediction. The dictionary says that it means “trust” or “full belief.” The word comes from the Latin fido, meaning “I trust.” The confidence crisis that we are in at the time of this writing is also called a credit crisis. The word credit derives from the Latin credo, meaning “I believe.”

Given these additional shades of meaning, economists’ point of view, based on dual equilibria or rosy versus bleak predictions, seems to miss something.² 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 a rational decision 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.

If this is what we mean by confidence, then we see immediately why, if it varies over time, it should play a major role in the business cycle. Why? In good times, people trust. They make decisions 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 the confidence disappears, the tide goes out. The nakedness of their decisions stands revealed.

The very term confidence—implying behavior that goes beyond a rational approach to decision making—indicates why it plays a major role in macroeconomics.³ When people are confident they go out and buy; when they are unconfident they withdraw, and they sell. Economic history is full of such cycles of confidence followed by withdrawal. Who has not taken a hike and come across a long-abandoned railway line— someone’s past dream of a path to riches and wealth? Who has not heard of the Great Tulip Bubble of the seventeenth-century Netherlands— a country famous, we might add, for its stalwart Rembrandt burghers and often caricatured as the home of the world’s most cautious people. Who does not know that even Isaac Newton—the father of modern physics and of the calculus—lost a fortune in the South Sea bubble of the eighteenth century?

All of which takes us back to Trondheim. Akerlof had stored the observation prompted by his relative’s million-dollar home in the wrong place in his brain. He should have seen that home prices in Trondheim were not merely indicative of curiously high real estate prices in Scandinavia; they were part of a worldwide real estate bubble. He had been too trusting.

But that takes us even further back, to Keynes’ passage about animal spirits. When people make significant investment decisions, they must depend on confidence. 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. They consider the probabilities of each of these options. And then they make a decision.

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—and even many of our own personal decisions about which assets to buy and hold—made much more on the basis of whether or not we have confidence? Do they not involve decision making processes that are closer to what we do when we flip a pancake or hit a golf ball? Many of the decisions we make—including some of the most important ones in our lives—are made because they “feel right.” John F. “Jack” Welch, the long-time CEO of General Electric and one of the world’s most successful executives, claims that such decisions are made “straight from the gut.” (We shall revisit him later.)

But at the level of the macroeconomy, in the aggregate, confidence comes and goes. Sometimes it is justified. Sometimes it is not. It is not just a rational prediction. It is the first and most crucial of our animal spirits.

The Confidence Multiplier

The most basic element of Keynesian economic theory is its notion of the multiplier. The concept, originally proposed by Richard Kahn as a sort of feedback system, was adopted by Keynes and became the centerpiece of his economic theory.⁴ Within a year of the publication of Keynes’ General Theory, John R. Hicks published a quantitative interpretation of Keynes that emphasized a rigid multiplier and the interaction of its effects with interest rates. Hicks’ version soon superseded Keynes’ original as the authoritative embodiment of Keynesian theory.⁵ Keynes was ruminating, discursive, disjoint, impenetrable, but nevertheless provocative and amusing; Hicks was orderly, efficient, and logically complete. Hicks’ version won the day. He is not as famous as Keynes, for he is often viewed as a mere interpreter of Keynes’ genius. But in terms of the history of thought, the “Keynesian revolution” was just as much a “Hicksian revolution.”

But we believe that the Hicksian embodiment of Keynes’ notions is too narrow. Instead of the simple multiplier that Hicks focused on, we should look at an allied concept, which we call the confidence multiplier.

The Keynesian multiplier, taught for generations to millions of undergraduates, works as follows. Any initial government stimulus, say a program of increased government expenditure, puts money into people’s hands, which they then spend. The initial government stimulus is the first round. Each dollar spent by the government ultimately becomes income to some people, and, once it has been put into their hands, they spend some fraction of it. That fraction is called the marginal propensity to consume (MPC). Thus the initial increase of expenditures feeds back into a second round of expenditures, made by people, not the government. This then feeds back again into income for yet more people, in an amount equal to the MPC dollars. These people in turn spend a fraction of the MPC, called the MPC squared dollars. This is the third round. But the story is not over yet. Round after round of expenditure follows, and so the sum of the effects of the initial expenditure of a single dollar by the government may be represented as $1 + $MPC + $MPC² + $MPC³ + $MPC⁴. . . . The sum of all these rounds is not infinite; it is in fact equal to 1/(1 – MPC), a quantity that is called the Keynesian multiplier. But the sum may be much larger than the original government stimulus. If the MPC is, say, 0.5, the Keynesian multiplier is 2. If the MPC is 0.8, the Keynesian multiplier is 5.

That idea was captivating for many people when Keynes articulated it in his 1936 book, and it was seized upon by Hicks in 1937. It was interpreted as explaining the mystery of the Great Depression. The Depression had been so puzzling because people could see no readily comprehensible cause for such an important event. The multiplier theory explained that a small dip in expenditure could have greatly magnified effects. If there were a small but substantial decline in consumption expenditures because people overreacted in fear to a stock market crash, such as the one of 1929, then this would act just like a negative government stimulus. For each dollar that people cut their consumption, there would be another round of expenditure cuts, then another and then another, resulting in a much larger decline in economic activity than would be attributable to the initial shock. A depression could come about over the course of several years, as the multiple rounds of negative expenditure hits put businesses further and further into the red. The theory won widespread acclaim—if not immediate policy implementation—for it sounded like just what was happening to businesses as the Depression increasingly deepened from 1929 to 1933.

Keynes’ multiplier theory also won popularity among econometricians because it could be quantified and modeled. Authoritative statistics on national consumption and income became available at around the same time as Keynes’ General Theory and Hicks’ interpretation of it were first published, and they provided the data sets for their analysis. The first estimates of national consumption data were published by the Brookings Institution in 1934.⁶ The U.S. National Income and Product Accounts were developed and put into a framework amenable to Keynesian-Hicksian theory by Milton Gilbert in the early 1940s.⁷ To this day the U.S. government, like the governments of other major countries, still produces national income and consumption data in accordance with the demands of this theory. Surprising as it may seem, given the huge volume of economic literature, no other macroeconomic model after that of Hicks has had such authority to dictate major changes in the way national data are collected. In a sense it is the data that dictate the theory that serves as the basis for formal modeling—for the data we have today were generated with but one theory in mind.

The creation of the data sets led to the development of large-scale computer simulation models for the economies of the countries of the world. This modeling started when Jan Tinbergen developed an econometric model of the Dutch economy in 1936 and a forty-eight-equation model of the U.S. economy in 1938. In 1950 Lawrence Klein developed another model of the U.S. economy, which grew over subsequent decades into the enormous Project Link, which linked together econometric models of every major country of the world, composed of thousands of equations. Such models have only a minimal role for animal spirits, and Keynes himself was skeptical of them.⁸

But it is possible to conceive of a role for confidence within these models. We usually think about multipliers only with respect to conventional variables that can be easily measured. But the concept applies equally well to variables that are not conventional and that cannot be measured so easily. Thus there is not only a consumption multiplier, an investment multiplier, and a government expenditure multiplier, which represent the change in income that occurs when there is, respectively, a $1 change in consumption, investment, or government expenditure. There is also a confidence multiplier. That represents the change in income that results 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 than in our earlier simple example of rounds of consumption expenditure. 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.

For a long time now there have been survey measures of “confidence.” The best known of these is the Michigan Consumer Sentiment Index, but there are others. Some statisticians have developed models that test for feedback from confidence to gross domestic product (GDP) using these data. There is little doubt that such measured confidence is a predictor of future expenditure. Causality tests for several countries suggest that current measured “confidence” does feed future GDP, and this result would seem to confirm the feedback implicit in the confidence multiplier.⁹ Other statisticians have performed similar analyses using credit quality spreads, measured as the difference between interest rates on risky debt and interest rates on less risky debt, interpreting these as measures of confidence and testing whether they feed into, and help predict, GDP.¹⁰ But we believe that such tests are actually of limited value. Even when such results are obtained strongly, that does not necessarily imply that animal spirits are playing a role. Why not? Because the measure of confidence may not be measuring them. Instead they may only be reflecting consumers’ expectations regarding current and future income.¹¹

And of course we would expect them to be predictive of future expenditure and income. It is also difficult to measure the effects of confidence on income bec...