Summary of "Animal Spirits" -- Akerlof and Shiller

Every major economic crisis represents an occasion to review the economic theories that purport to explain it, and the policy choices used to combat it.

The US is slowly emerging from a major recession brought on by a collapse of confidence in a highly complex financial system. Technically, the recent recession appears to be over, since GDP is slowly growing, but as with the recoveries from other recent recessions, the recovery in employment is very slow.

While conventional economic theory assumes economic agents are strictly rational, Keynes cautioned that economic fluctuations are largely driven by "animal spirits" that are more easily explained by psychologists than by economists. Akerlof and Shiller's book Animal Spirits explore various types of "animal spirits" and explain how they affect the economy.

In the first part of the book, they identify five elements of human psychology that contradict the assumptions of mainstream economic theory, and explain a great deal about recent economic cycles:

  1. confidence
  2. fairness
  3. corruption and bad faith
  4. money illusion
  5. stories
Confidence: Any economic activity requires some degree of confidence in the consequences of any action. There is a clear feedback between market confidence and the economy. High confidence stimulates spending, investment, employment and production. The resulting income growth reinforces that confidence. Conversely, low confidence makes consumers save more and spend less, and makes firms invest, hire and produce less. Declining incomes undermine market confidence even more.

Market expectations tend to be self-fulfilling in the short run but self-correcting in the long-run. Akerlof and Shiller argue that a "confidence multiplier" affects the economy just like an ordinary consumption multiplier, or causes the ordinary multipliers to vary over time. Speculative bubbles feed on the optimism they generate until they burst.

Fairness: People are often motivated by a sense of fairness that moderates raw self-interest. Many workers will choose unemployment over unfair wages. Employers are very aware that fair payscales maintain employee goodwill.

Corruption and bad faith: Markets provide what people want, even if it's snake oil sold by hucksters. This is the rationale for consumer protection laws. Most personal wealth today is held in bank accounts, stocks, mutual funds, etc., rather than in tangible physical assets. Proper valuation of these assets depends on truthful accounting of current capital positions and cash flows, and honest projections of future earnings. The 2001 Enron scandal shows how "creative" accounting intended to sustain the company's stock price evolved into massive criminal fraud. Ironically, the corporate accounting frauds of the 1990's (Enron, Worldcom, HealthSouth, etc.) caused many investors to turn from stocks to real estate, which helped drive the more recent real estate bubble.

Money illusion: The Phillips curve traces an inverse relationship between an economy's unemployment rate and its inflation rate. In the US economy, relationship remained quite stable for decades, until the late 1960's when it started spiraling wildly in response to a series of energy price shocks. Milton Friedman argued that government policies to push unemployment below its "natural" rate had created "rational expectations" of inflation. He rejected the conventional theory of money illusion--that workers focus on nominal rather than real wages. Friedman contended that workers incorporate "rational expectations" of future inflation into their wage demands. And since employers generally accede to these demands, inflationary expectations are self-fulfilling. The only cure for such self-perpetuating inflation was a recession severe enough to break these expectations, such as the 1982 recession.

Akerlof and Shiller argue for a more nuanced view of money illusion. Recall that the 3 functions of money are as a medium of exchange, store of value, and unit of value. Consumers only see nominal prices, wages, bank balances, etc. Labor contracts rarely contain COLA's. Most mortgages are fixed-rate. In times of low inflation, we accept money illusion because it is convenient and costs little. Rational expectations come into play mostly during periods of higher inflation.

Stories: Humans think in terms of narratives, and structure their identities through stories of their lives. Similarly, racial and ethnic groups are defined by shared stories. And whole economies may be driven by national stories.

In the second part of the book, Akerlof and Shiller address eight economic questions in the context of these "animal spirits:"

  1. Why do economies fall into depression?
  2. Why do central bankers have power over the economy (insofar as they do)?
  3. Why are there people who cannot find jobs?
  4. Why is there a trade-off between inflation and unemployment in the long run?
  5. Why is saving for the future so arbitrary?
  6. Why are financial prices and corporate investments so volatile?
  7. Why do real estate markets go through cycles?
  8. Why is there special poverty among minorities?

Why do economies fall into depression? Classical economic theory does not explain long-term involuntary unemployment well. Unemployed workers should simply reduce their wage demands until someone is willing to hire them. But lack of confidence about liquidity, availability of capital and future demand may discourage firms from hiring additional workers. Second, perceptions of fairness and (in some cases) money illusion tend to make wage structures downwardly-rigid. If the economy experieces actual price deflation, it may fall into a "liquidity trap" where people hold money instead of spending it because its purchasing power is rising. This reduces aggregate demand, which leads to further layoffs. The classic prescriptions are deficit spending by the government and monetary expansion.

The flat performance of the stock market since the late 1990's followed a series of massive stock frauds (Enron, WorldCom, etc.) which made housing look like a comparatively safer investment. This new demand for housing triggered the speculative housing bubble of the last decade. Rising home prices were sustained by sub-prime mortages that were aggregated into huge mortgage portfolios for resale, with their payment streams sliced into "tranches" for investment bank and hedge fund portfolios, with additional liquidity supported by various markets for derivatives and credit default swaps based on these tranches.

Unlike prior recoveries, the economic recoveries after the 1982, 1990, 2001 and 2008-9 recessions did not involve much job creation.

Why do central bankers have power over the economy (insofar as they do)? Recall the basic theory in which banks create money by recycling deposits as loans, and the central bank has three basic ways of managing money supply growth: open-market operations (buying or selling financial assets), adjusting the interest rate it charges member banks for overnight lending to satisfy their reserve requirements, and adjusting bank reserve requirements. This theory doesn't account for the Fed's gradual loss of control as de-regulation allowed banks and insurance companies to develop new liquidity instruments outside the Fed's regulatory purview. (As we shall see later on, insurance creates liquidity.)

The Fed has maintained short-term interest rates near zero for an extended period. This is the limit of effectiveness of conventional monetary policy, and has not resolved the current recession.

Why are there people who cannot find jobs? As noted above, efficient market theory fails to explain long-term unemployment. In reality, employers don't just buy undifferentiated labor hours. The relationship beteween employer and employee is far more complicated. Firms need employees with specific skills to work specific schedules, and they want to maintain employee morale. There is a principal-agent problem: the employer has to trust the employee to do quality work, and a wage premium buys employee loyalty and quality work. Also the presence of involuntary unemployment helps stabilize wage demands, making employees feel lucky to have jobs and keeping them from shirking.

Why is there a trade-off between inflation and unemployment in the long run? Friedman's "natural rate" theory is based on a rejection of money illusion, and implies that if the Fed just focuses on price stability unemployment should take care of itself. Akerlof and Shiller compare the different experiences of the US and Canada in the 1990's, where the tight monetary policies of the Bank of Canada, following Friedman's prescription, brought Canada's inflation down to 1.8% while driving unemployment to 11.3%.

Why is saving for the future so arbitrary? Young people have difficulty planning for the long term, and their saving behavior is pretty random. But longer-term saving is more affected by compounding. Workers typically give minimal thought to enormously consequential decisions regarding their retirement plans. The contrast between US and Chinese savings is due as much to cultural differences as to differing economic incentives. American consumer culture emphasizes immediate gratification, supported by credit cards. High credit card interest rates imply high rates of time preference for consumption financed with those cards.

Why are financial prices and corporate investments so volatile? In a world of complete information, stock prices would reflect the discounted stream of projected company profits pretty closely. The variability of individual stock prices as well as overall stock market indices shows how, in the absence of full information, stock prices are driven more by animal spirits (which may drive or interact with "technical" indicators) than by rational market "fundamentals." Corporate managers have strong incentives to pump their stock prices, and recent corporate scandals show how creative corporate accounting can yield grossly exaggerated valuations of a company.

Successful investing involves picking profitable companies over the long run. But most investors looking for quicker profits are focused on anticipating herd behavior and picking stocks that will become popular with other investors. Akerlof and Shiller use the metaphor of Red Delicious apples: they may taste lousy, but they have excellent shelf life and resistance to bruising, their shape and color epitomize what an apple is supposed to look like, and most people believe other people like them!

Financial markets show the effects of confidence multipliers. A company's stock price falls, so its credit rating suffers, its cost of credit increases, it invests less, its growth rate falls, etc., driving further declines in its stock price. Or a company's stock rises, so it can borrow and invest more and grow faster, boosting its stock price even more. The volatility of Oil and other resource prices reflects similar feedback effects. The stories people tell each other about these markets include a lot of exaggeration.

Why do real estate markets go through cycles?\ The US real estate market went through a classic speculative bubble as rising prices reinforced investor demand, abetted by easy credit and very high leveraging. Land values ought to increase in line with other assets. Of if they are tied to agricultural commodity prices, which keep falling relative to other prices, they should appreciate more slowly than other assets. The tax deductibility of home mortgage interest makes homeownership preferable to renting, but this advantage is already capitalized into home prices. So there is no rational reason why real estate investment should be any more profitable than other types of investment.

Why is there special poverty among minorities? Poverty rates are consistently higher among minority groups in the US, particularly among blacks. The American black demographic has split in the last few decades, with a large portion achieving economic success in suburban communities, while another large portion remains mired in urban poverty. The stories that blacks and whites tell themselves are radically different. Small differences in how groups perceive themselves in relation to the society become magnified. Perceptions of victimization can be self-fulfilling. Parents who failed in school are unlikely to provide strong support for children who are failing in school.

In hindsight, the recent economic crises--the collapses of Enron, housing prices, Bear Stearns and Lehman Brothers, AIG, etc.--are all explainable by an economic theory that takes account of these animal spirits. Likewise, a number of enduring social problems can be addressed more efficiently with policies that account for the role of animal spirits behind them.