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Recession and how we got into it

Posted on February 18, 2009 by Richard Beddard
Filed Under Markets |

Because we’re human

Animal Spirits

The central point of Animal Spirits by professors George Akerlof and Robert Shiller1, is that economic theory, and economic models, don’t work. Far from being part of the solution to our economic woes, they’re part of the problem.

An interesting subtext, bearing in mind the econ. blog wars between vying schools of economic thought2, is that economics wasn’t always so lame. Akerlof and Shiller are building on the work of older Economists, principally John Maynard Keynes, whose work, they say, modern economists dumbed-down and misinterpreted.

To my untrained eye, it looks increasingly like economists took a wrong turn in the second half of the twentieth century and the discipline is only just getting itself back on track. There are parallels in financial analysis, where modern theories also removed human nature from the equation.

Part one of the book describes the animal spirits, a term borrowed from Keynes, that lead people to make irrational decisions but are surprisingly absent or diluted in economic theory. It’s similar to chapters in Robert Shiller’s previous books, Irrational Exuberance, and The Subprime Solution, but with each successive book, he refines his thinking.

Here are four3 of the spirits that help to explain the current economic crisis, and how it caught-out most conventional economists:

  1. Confidence. We suspend disbelief when times are good, taking impulsive risks we’d avoid in less confident times. Irrational confidence, for example, leads bankers to trust toxic debt when it’s making them money. The absence of confidence causes credit markets to freeze, when it isn’t. But confidence (or lack of it) is difficult to model, so by-and-large economists haven’t tried.
  2. Corruption and bad faith. Corruption ebbs and flows with the economy too. The authors say it’s no coincidence that the last three recessions in the US (1990/91, 2001, and the current one) were all preceded by ‘predatory’ activity (The Savings and Loans crisis, Enron, and subprime lending). We lower our principles when we think we can get away with it, and when new opportunities, like relaxed regulation present themselves.
  3. Money illusion, or thinking in nominal (dollar/pound) amounts without taking account of inflation. I think the most striking example is from Shiller’s earlier book, ‘The subprime Solution’, in which he shows money illusion lead investors to believe property is a good investment at any price. Because we buy and sell houses infrequently, past gains look enormous. Accounting for inflation, though, the returns are much less impressive.
  4. Stories. Inspirational stories spread like epidemics, breeding more confidence. In the 1990’s an important technology, the Internet, became the catalyst for ‘new era’ story that propelled the stockmarket boom. Technology has dominated economic growth for centuries, though, and from that perspective, the Internet was no more special than the telegraph, or television.

Economic theory ignores or sidelines animal spirits, so economic policy doesn’t take account of them. Could it? In part two, the authors promise:

…we will develop our own theory of economic instability, or economic problems and of our suggested strategies for solving them, and also offer our prescription for how to deal with the current economic and financial crisis.

Footnotes:

  1. I’ve only read the first sixty pages, less than half the book, so this isn’t a full review
  2. Mercifully, Akerlof and Shiller seem to be above it.
  3. The fifth is fairness. The authors’ site research that notions of fairness often trump rational economics when it comes to decision-making, but none of it is directly relevant to the current economic crisis. For example, retailers apparently resist the temptation to gauge prices supply is short, despite the law of supply and demand.
Category: Markets

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