Animal Spirits

Animal Spirits by George A. Akerlof and Robert J. Schiller1

Premise

The basic premise of Animal Spirits is that people are not purely rational creatures, and that emotions or "animal spirits" play a large role in determining behavior. The authors argue that this has important implications for how we manage the economy and for the role of government. Broadly speaking, they argue that unregulated markets are not stable and not the best way of organizing the economy, and that government intervention is frequently needed. They say that economic fluctuations are caused by animal spirits — by changing thought patterns.

I don't doubt that emotion plays a large part in decisions. I believe that people act against their own long-term interests sometimes. But the authors' analysis often seems to over-reach, and there is little or no hard data here to support their theory.

It's certainly true that free markets exhibit "manias and panics".

What Are the Animal Spirits?

  • Confidence - feedback mechanisms amplify disturbances due to changes in confidence
    • Trust or belief determines investment decisions — these are not always rational
    • Confidence has a multiplier effect
    • Annoyingly, the authors recognize that economists do measure confidence, but then argue that these surveys do not measure trust in their meaning of the word. Then what is it, and what can you do about it?
  • Fairness - affects setting of wages and prices
    • There's lots of experiments that show that people are influenced by fairness
    • Fairness can trump pure economic motivations e.g. hardware stores don't charge more for snow shovels after snowstorms, people will pay more for the same beer if it comes from a swanky hotel instead of a beach shack (page 22). People in experimental games will punish others for acting selfishly. They cite Kahneman and Tversky2,3 and Kahneman, Knetsch and Thaler4,5 and Fehr and Gachter6.
    • Exchange has social dimensions e.g. between high and low-status individuals
    • People want to be seen as fair; social norms are powerful in exchange
  • Corrupt and antisocial behavior - I am less impressed by this argument. Can these not be rational?
    • Capitalist societies also produce snake oil
    • The authors point out that each of the last three U.S. recessions was associated with a corruption scandal: the S&L crisis in 90-91, Enron in 2001 and subprime mortgages in 2007. But does correlation prove causation? I guess you can say that corruption indicates that something was wrong in market valuations, and corrupt actors exploited that.
  • Money illusion - people are confused by inflation or deflation. I buy this. This has some technical implications.
    • Many contracts don't account for inflation. That is evidence of "money illusion", which Milton Friedman said is irrational and therefore not correct.
    • The authors argue ( and I agree) that there are many examples of money illusion in the economy
  • Stories - our sense of reality and of who we are is guided by stories. It's not clear to me how stories guide the economy, as the authors assert
    • The human mind thinks "in terms of narratives". I agree that stories — at the least — aid retention. (Note to self: use many stories in the book!)
    • Interesting! Some assert that there are only a small number of basic narratives. Georges Polti identifies thirty-six basic dramatic situations7. Ronald Tobias said in 1993 that there are just twenty fundamental plots: "quest, adventure, pursuit, rescue, escape, revenge, riddle, rivalry, underdog, temptations, meta-morphosis, transformation, maturation, love, forbidden love, sacrifice, discovery, wretched excess, ascension, and descension."8
    • They argue that stories can move the markets. I suppose that can be true sometimes. The authors emphasize "new era" stories.

How Animal Spirits explain the Behavior of the Economy

Here the authors apply themselves to several economic problems, such as depressions, unemployment, financial price volatility and others. Some of these explanations are more convincing than others. The authors claim that "animal spirits provide an easy answer to each of these questions" (page 6). That is a pretty arrogant assertion, and it's not supported in the book. At most, the ideas they propose are starting points for further research, although how do we identify when the "national story" has changed?

  • Depressions - The authors argue these are caused by a crash of confidence, corruption, unfairness and money illusion (unwillingness to adjust wages). I find it plausible that confidence is a big factor, and that money illusion impedes adjustment.
  • The Fed and the Current Financial Crisis - The authors argue for credit targets as well as traditional policy instruments
  • Unemployment - caused by labor markets' failure to clear
    • Fairness inhibits wage adjustment
    • The efficiency wage theory is one explanation of firms' unwillingness to cut wages
    • There is a high correlation between the pay in different industries by occupation, so industries that pay more to bosses also pay more to secretaries. Workers at the same skill level receive very different wages9.
    • People really care about being treated fairly. Their is a complex relationship between workers and their employers.
    • "…unemployment is exactly caused by wages in excess of market clearing." (page 103).
  • Inflation/Unemployment Trade-Off - due to wage rigidity (fairness and money illusion).
  • Saving is Arbitrary - people do not understand compounding, are influenced by framing, desensitized to spending by credit cards etc.
    • I agree with this observation from page 123: "If, by assumption, people's decisions regarding saving are optimal, then whatever happens, they must be saving exactly the right amount. But that, of course, has assumed away the problem."
  • Financial Price Volatility -
    • Asset markets affect the real economy: asset price increases reduce the incentive to save; capital investment drops with stock prices; people do not pay their debts.
    • Feedback is enhanced by a leverage cycle (cites Geanakoplos).
  • Real Estate Cycles - Due to leverage, naive beliefs, stories.
  • Poverty Among Minorities - Affirmative action, the authors claim, is a symbol of fairness. They advocate more resources for education of minorities.

Conclusion

  • Authors have a classification of how people behave: a 2x2 box, with motives that are economic or not economic, and responses that are rational or irrational. They argue that "the current model fills only the upper left-hand box." (page 168).
  • Their explanation of the current financial crisis on pages 169 and 170 seems to me to combine conventional explanation with some of their own ideas.
  • Conclude that "capitalism must live within certain rules" (p 173).
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