Animal collective

• Last Updated: March 27. 2009 9:30AM UAE / March 27. 2009 5:30AM GMT

Why would nearly all investors simultaneously make the same mistake, year after year? The answer is speculative mania – a concept for which there’s ample empirical support but for which a rationalist model has no place. Caetano Barreira / Reuters

Matthew Yglesias reads a timely manifesto for the abandonment of economic orthodoxy.

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism
George A Akerlof & Robert J Shiller
Princeton University Press
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Adam Smith observed in The Wealth of Nations that “it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”. A rational person, in other words, quickly realises that it makes little sense for him to do everything for himself. Instead, he specialises. He bakes, farms or works construction, and he trades with others to meet his needs. And the better the baker gets at baking, the better off his customers become. The baker’s efforts at self-improvement could be motivated by nothing more elevated than simple greed and still the public at large would benefit.

From this insight sprang a conceptual revolution. Previously, it had seemed logical to suppose that improvement in the human condition could spring only from improvement in the human character – from making us more generous or charitable – and that if such improvement was, as seems likely, impossible, we would have to seek our solace in the afterlife rather than in better public policy.

This idea is central to economics, a discipline aimed at understanding the institutions and processes that turn human selfishness into wealth. With it came the hope that improvements in modelling human behaviour along rational lines would lead to improvements in understanding the world and its workings. Economics has since had impressive success, and it now stands at the pinnacle of the social sciences, regarded with a good deal more prestige than sociology, anthropology and all the rest. This triumph rests in part on real achievements, but also on the fact that modern-day economics relies not on Smith-style narratives but on complicated mathematical equations. This makes the work look more like physics than history, and lends it an air of rigour and precision.

But this apparent precision rests on a fragile foundation: the model of human beings as rational actors. Smith contended that rational self-interest on its own – without the intervention of governments or authorities – could produce beneficial results for society as a whole. Over time, this point came to be represented by formal mathematical models; devising better models became a key trait of the skilled economist. For some, however, the idea took hold that the models were not just approximations, but descriptions of reality: they were just not yet sophisticated enough to fully prove the ability of the rational agent approach to illustrate every aspect of human behaviour. Thus arose a boom market in clever attempts to explain away apparently irrational behaviour as, in fact, perfectly rational. Situations that the model could not explain did not disprove the model, they merely indicated a need for further refinement.

Looking around, however, it doesn’t seem to be true that people consistently act to maximise rational self-interest. In the world that I live in, people take up smoking and spend weeks forgetting to turn in their retirement plan enrolment form simply because they can never seem to find the time to take the lift to the right floor to hand it in. People lend money to friends at no interest – even to friends who aren’t always the best at paying off their debts. They use credit cards more than they can afford, they join terrorist groups, they quit their jobs to go surfing in the Pacific. More consequentially, they react to stock market plunges by shying away from investment even though a sharp decline, logically speaking, makes stocks a better buy.

Economists often say that this must all be perfectly rational, even if we don’t yet know how to explain it. But perhaps the impetus for our behaviour – and the fluctuations in the economy that result – is what John Maynard Keynes called “animal spirits”: “a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities”. Rational investors would just buy and hold broadly diversified stock indexes, but if everyone did this there would be no investment in new businesses. A certain amount of unwise risk-taking is necessary to make the world go ‘round, but the irrationality at the heart of the system makes it prone to hiccups and disasters.

George Akerlof and Robert Shiller’s Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism is a plea to start believing our lying eyes rather than the model. Rather than try to explain away the apparent irrationality in human behaviour, Akerlof and Shiller say we need to try to understand it and shape policies that take it into account.

Both men have long made similar arguments. Akerlof won the 2001 Nobel Prize in economics for his work on market imperfections caused by asymmetrical information. Shiller is a leading scholar of bubbles and financial panics, who was first infamous, and is now simply famous, for his insistence in the past few years that the American housing market was due for a crash. Their book is billed as the result of a lengthy collaboration, but has a somewhat disjointed feel, as if it was rushed out to catch the wave of interest in the subject amid the current financial crisis. Despite the cost in coherence, it’s a good thing it was. The arguments for strong rationality assumptions have never been very good, and neither Akerlof or Shiller came to their current views because of the current crash; but the crash provides a moment of psychological shock in which persuasive arguments can ease people out of their current assumptions.

After all, part of the problem with the traditional view is that it’s quite difficult to see how one might actually disprove it – its adherents are in the habit of citing the model itself as a refutation of apparent counter-evidence. For example: by 2005, US home prices were well above their historical average, leading some to conclude that we were in an unsustainable bubble that would soon burst. Alan Greenspan, then the chairman of the Federal Reserve and a strong defender of the rational-actor orthodoxy, argued to the contrary that since it wouldn’t make sense for a bubble to form – since rational homebuyers wouldn’t have inflated one – what we were looking at could not possibly be a bubble.

“For homeowners to realise accumulated capital gains on a residence,” he observed in June 2005, “they must move” – they must sell their homes, an obviously inconvenient transaction. In other words: it wouldn’t makes sense for the rapid rise in house prices to be the result of widespread speculation, so that must not be the cause. And, indeed, it didn’t make sense for people to count unrealised capital gains on their homes as if it were money in the bank, and to respond to notional appreciation in home value by spending beyond their income and racking up credit card and home-equity debt – but that’s what they did.

Akerlof and Shiller argue that such phenomena are actually quite common: the economy is driven not just by the impersonal forces of supply and demand but by “animal spirits” within human culture. During an upswing, powerful narratives take hold and prompt people to take bold risks. Stories of day traders making easy money in the markets and of young geeks making billions overnight dominated the headlines throughout the dot-com boom, while the housing bubble generated endless stories about newly rich home-flippers. The prevalence of such tales ought to signal that a bubble is under way and it’s time to start betting on a turnaround. But in practice, the tendency is for people to be taken in by the wave of enthusiasm.

Conversely, when the party starts to end we tend to fall into a funk. Instead of responding to recession-inspired discounts by heading to the mall, even people with secure jobs start pulling back. And just as rationalist economics predicts that bubbles shouldn’t occur, it suggests that recessions should be brief and self-correcting. A rise in the unemployment rate should swiftly lead to a reduction in wages, at which point increased hiring becomes profitable and the unemployment vanishes. This theory is, as Akerlof and Shiller argue, not without its virtues. “Few people ask why employment was as high as 75 per cent in 1933,” they observe, precisely because we take the classical model’s ability to explain most of what happens for granted. The interesting questions concern what the classical model leaves out – the unemployed minority rather than the employed majority. But in the midst of a crisis, a theory that tells you to do nothing in response to the mass unemployment that can’t exist, which has emerged after the bursting of a bubble that also can’t exist, is not very helpful.

This has, of course, occurred to economists before, most famously Keynes and those working in his tradition. But most modern-day Keynesians toil trying to domesticate Keynesian theory by showing how its key precepts can be accounted for in classical terms. The core message of Animal Spirits is that we should stop trying to cage the spirits and instead admit their central importance. Specifically, this means that world governments will need to intervene forcefully in the current economic crisis with both fiscal stimulus and direct measures to stimulate lending – to restore some of the confidence that the crash has sapped.

Attention to the spirits suggests that the American and British governments are probably wrong to resist pressure from continental Europe to make regulatory reform a top priority. The English speakers say that since the world is suffering from an epidemic of risk-aversion, there’s no urgent need to go about the difficult business of writing rules to prevent imprudent risk-taking in the future. But this ignores the psychological aspects of the situation. The downwards turn in our animal spirits is, in part, a loss of confidence in the system. Akerlof and Shiller write that “if we wish to understand the functioning of the economy, and its animal spirits, we must also understand the economy’s sinister side” – fraud and corruption. Headlines about Bernie Madoff blend with pervasive anecdotes about fraudulent mortgage applications.

The system, in short, looks broken and corrupt. Infusions of cash designed to fix it make it look more broken and more corrupt. Under these circumstances, issues that experts are inclined to dismiss as “symbolic” or otherwise unimportant, like the furore over AIG bonuses, can actually be of central importance. Narratives of corruption erode trust, which in turn diminishes the desire to consume or invest, deepening the downturn.

A global economy predicated on the notion of self-correcting markets has clearly failed. And while thus far policymakers have engaged in a great many emergency measures to prevent things from completely falling apart, they’ve given us few clear signs that they intend to build a new system or rebuild anything more like the older, more regulated capitalism of the mid-20th century. But with the theoretical foundations of market purism looking shaky and the practical consequences looking disastrous, it’s doubtful that ordinary people around the world will feel inclined to risk their time or wealth on new ventures. Meanwhile, policymakers – especially in the United States – seem to remain in the grips of the same rigid orthodoxy that allowed the current crisis to spiral out of control.

The Great Depression led to the implementation of a regulatory regime that, though crude, served to prevent panics from becoming contagious and banks from becoming “too big to fail”. This framework was eroded by the belief that a market populated by rational actors could police and correct itself. After all, why would nearly all investors simultaneously make the same mistake, year after year? The answer, of course, is speculative mania – a concept for which there’s ample empirical support but for which a rationalist model has no place. The cure is not to abandon capitalism, but to ditch excessive faith in the rationalist model and make sure that regulations keep us well-clear of the ledge, lest inevitable bouts of irrationality push us into an abyss.

Matthew Yglesias is a fellow at the Center for American Progress, and the author of Heads in the Sand.