All Commentary
Wednesday, August 25, 2010

Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism

Neoclassical economic theory (in which I include Austrian economics, ignoring the methodological differences) doesn’t explain everything in the world, not even everything that occurs in what is considered the economic realm. In recent years this has been the theme of the growing subdiscipline “behavioral economics,” which has, often usefully, focused attention on economic anomalies—outcomes inconsistent with the predictions based on fully informed and perfectly rational actors.

This isn’t surprising, given the usefulness of making simplifying assumptions in theoretical endeavors. Obviously no one is fully informed or perfectly rational, but the assumption that they are generates remarkably accurate predictions on issues that interest economists.

One of the most powerful implications of neoclassical economics is that the case for free markets doesn’t depend on people being fully informed and rational, as is mindlessly repeated in many principles textbooks. Quite the contrary, the case for markets is that they increase the rationality of economic decisions by providing information and motivation through prices, profits, and losses that cannot exist without markets.

With that as background, I review Animal Spirits by George Akerlof and Robert Shiller. Both Akerlof and Shiller have done creative and interesting work, much of it based on the anomalies highlighted in behavioral economics. They begin by considering how “animal spirits” affect economic decision making. That term originated with Keynes, who used it to describe emotional factors that enter into, and often distort, investment decisions that are necessarily made with incomplete information.

Akerlof and Shiller take a more expansive view of animal spirits, which they break into five categories: confidence, fairness, corruption and antisocial behavior, money illusion, and stories. The five chapters in Part 1 discuss those separately, showing how they can lead to irrational economic outcomes and how understanding them can help us design appropriate policies for correcting them. The remaining chapters look at how animal spirits may be responsible for the current economic downturn.

Not having the space to deal with each of these chapters individually, I’ll keep my discussion general. Although Akerlof and Shiller suggest that they appreciate the importance of markets, their emphasis is clearly on “market failure.” A few examples illustrate their tendency to qualify any positive statement about capitalism (emphasis in original): “Capitalist societies . . . can be tremendously creative. . . . On the other hand, left to their own devices, capitalist economies will pursue excess, as current times bear witness.” “But the bounty of capitalism has at least one downside. It does not automatically produce what people really need; it gives them what they think they think they need, and are willing to pay for.”

This last statement isn’t blatantly false, although it puts the free market in the worst possible light by suggesting that many consumers want “snake oil.”

A more balanced approach would have also pointed out that government doesn’t automatically provide what people need either; it gives everyone what the majority, or a politically influential few, think they need, whether or not they’re willing to pay for it. Such a comment is nowhere to be found. Akerlof and Schiller ignore the problems with the perverse outcomes of government actions.

Sometimes the authors show their bias with the tone of their statements. For example, they state that “[t]he proponents of capitalism wax poetic over the goods that it provides” (emphasis added). And they refer to Milton Friedman’s “sleight of hand” when describing his analysis of the fallacy behind the Phillips curve—analysis that undermined, at least intellectually, the fiscal excesses of government that brought us the stagflation of the 1970s.

Akerlof and Shiller use “animal spirits” to consider some important economic issues in different and potentially productive ways. But for this concept to realize its potential it would have to be used to develop hypotheses that are more discriminating and testable than anything found in Animal Spirits.

The authors give the impression that they see “animal spirits” as an all-purpose explanation to be trotted out to explain anything that cannot be readily explained with existing economic theory. Indeed, they seem to believe that the strength of their approach is that by explaining almost everything, it cannot be refuted.

“Animal spirits” are ubiquitous and surely play a role in much economic activity. When economic questions cannot be adequately answered with existing theory, however, the way to come up with better answers involves hard work in developing refutable hypotheses, then testing them. That isn’t what Akerlof and Shiller do. They use animal spirits as the answer to the questions they consider in much the same way oxygen can be used as the answer to the question, “What caused the fire?” The answer cannot be refuted, but it’s not very helpful