Alex Curran, Stevie Gerrard's missus, has said that the recession is causing her to cut her spending. To orthodox economics with its rational maximizing people, this makes no sense. The downturn isn’t hitting Stevie G’s earning power or permanent income, so why should it reduce her spending?
It’s in this context that George Akerlof and Robert Shiller’s new book, Animal Spirits, comes to the rescue.
We cannot, they say, understand major economic events without paying attention to “the thought patterns that animate people’s ideas and feelings, their animal spirits.”
These spirits, they say, comprise five different aspects: confidence, fairness, corruption, money illusion, and stories. These aspects can generate booms and slumps. I suspect three of these lie behind Ms Curran’s cutbacks. Though the recession is not materially hitting her, it’s sapping her confidence; she’s telling a story in which the recession means that people are becoming more frugal; and she might think it unfair to go on spending sprees when others cannot. Through these routes, the recession is bigger than it would otherwise be, because Ms Curran - and millions like her - cut their spending too.
Akerlof and Shiller explain how the other two fit into booms and slumps. In booms, confidence is high. People trust each other and get greedy for high returns. So Madoff and Stanford thrive. Money illusion matters too. It causes people to over-estimate long-run returns on house prices - thus contributing to the boom in them. And as it causes workers to resist nominal pay cuts, downturns in demand lead to big falls in employment.
All of this is overlooked by orthodox economics with its rational utility maximizes. Akerlof and Shiller are too polite to say so, but I suspect the emphasis put upon the max U story in universities is in part due not to its factual accuracy - though as Akerlof and Shiller concede this is not wholly lacking - but to the fact that it generates nice mathematical exam questions.
So, how well does their story fill the gap?
No doubt, you can’t understand the housing market or capital spending decisions without animal spirits. In this sense, they score big hits. But I fear they are stretching a little in trying to apply their story to minority poverty. And I’m not sure animal spirits - in the sense of pure irrationality - is the whole story behind stock market volatility; I’d have welcomed a discussion of Patrick Minford’s idea that small changes in the probability of disaster or boom can rationally generate high volatility.
I’d also have welcomed more on how exactly the “confidence multiplier” works. Yes, confidence raises asset prices which in turn raise investment. But how is it that sometimes confidence leaps from one person to another - causing big booms - and sometimes it doesn’t, with the result that we get economic stability? There’s a single line of how stories can spread like epidemics, but no discussion of, for example, Christopher Carroll’s work on the epidemiology of expectations.
There are a couple of other gaps that might have strengthened their argument. There’s no mention of work in neuroeconomics (survey pdfs here and here) by the likes of Drazen Prelec or Colin Camerer, even though this is perhaps undermining the notion of a single, united rational self.
An even bigger gap is the lack of any discussion of Austrian economics. As it stands, Animal Spirits contrasts rational homo economicus with skittish irrational Alex Currans. But the Austrians give us a third way. The facts necessary for rational calculation are often missing or unknowable; as G.L.S Shackle said, knowledge of the future is a contradiction in terms, and - I‘d add - bosses rarely know workers‘ marginal products. In conditions of such unavoidable ignorance, animal spirits are all we have to motivate economic actions. It’s not that people are irrational - it’s that they just haven’t the tools to be rational with.
Which leads me to another issue; is the ubiquity of animal spirits really a bad thing? Maybe not. Daniel Gross has shown that bubbles leave a benign legacy; those condos in Miami may be worth only a fraction of what they cost, but they put roofs over folks’ heads. And Robert Lucas has shown (pdf) that the average costs of economic fluctuations are small and can in principle in shared by using better markets in risk - which Shiller’s own superb work has helped demonstrate.
What’s more, given that the private benefits of innovation are low, and the probabilities of success in many arts and industry small, it might be only animal spirits that give us artists and entrepreneurs. As Richard Nisbett and Less Ross wrote years ago:
It’s in this context that George Akerlof and Robert Shiller’s new book, Animal Spirits, comes to the rescue.
We cannot, they say, understand major economic events without paying attention to “the thought patterns that animate people’s ideas and feelings, their animal spirits.”
These spirits, they say, comprise five different aspects: confidence, fairness, corruption, money illusion, and stories. These aspects can generate booms and slumps. I suspect three of these lie behind Ms Curran’s cutbacks. Though the recession is not materially hitting her, it’s sapping her confidence; she’s telling a story in which the recession means that people are becoming more frugal; and she might think it unfair to go on spending sprees when others cannot. Through these routes, the recession is bigger than it would otherwise be, because Ms Curran - and millions like her - cut their spending too.
Akerlof and Shiller explain how the other two fit into booms and slumps. In booms, confidence is high. People trust each other and get greedy for high returns. So Madoff and Stanford thrive. Money illusion matters too. It causes people to over-estimate long-run returns on house prices - thus contributing to the boom in them. And as it causes workers to resist nominal pay cuts, downturns in demand lead to big falls in employment.
All of this is overlooked by orthodox economics with its rational utility maximizes. Akerlof and Shiller are too polite to say so, but I suspect the emphasis put upon the max U story in universities is in part due not to its factual accuracy - though as Akerlof and Shiller concede this is not wholly lacking - but to the fact that it generates nice mathematical exam questions.
So, how well does their story fill the gap?
No doubt, you can’t understand the housing market or capital spending decisions without animal spirits. In this sense, they score big hits. But I fear they are stretching a little in trying to apply their story to minority poverty. And I’m not sure animal spirits - in the sense of pure irrationality - is the whole story behind stock market volatility; I’d have welcomed a discussion of Patrick Minford’s idea that small changes in the probability of disaster or boom can rationally generate high volatility.
I’d also have welcomed more on how exactly the “confidence multiplier” works. Yes, confidence raises asset prices which in turn raise investment. But how is it that sometimes confidence leaps from one person to another - causing big booms - and sometimes it doesn’t, with the result that we get economic stability? There’s a single line of how stories can spread like epidemics, but no discussion of, for example, Christopher Carroll’s work on the epidemiology of expectations.
There are a couple of other gaps that might have strengthened their argument. There’s no mention of work in neuroeconomics (survey pdfs here and here) by the likes of Drazen Prelec or Colin Camerer, even though this is perhaps undermining the notion of a single, united rational self.
An even bigger gap is the lack of any discussion of Austrian economics. As it stands, Animal Spirits contrasts rational homo economicus with skittish irrational Alex Currans. But the Austrians give us a third way. The facts necessary for rational calculation are often missing or unknowable; as G.L.S Shackle said, knowledge of the future is a contradiction in terms, and - I‘d add - bosses rarely know workers‘ marginal products. In conditions of such unavoidable ignorance, animal spirits are all we have to motivate economic actions. It’s not that people are irrational - it’s that they just haven’t the tools to be rational with.
Which leads me to another issue; is the ubiquity of animal spirits really a bad thing? Maybe not. Daniel Gross has shown that bubbles leave a benign legacy; those condos in Miami may be worth only a fraction of what they cost, but they put roofs over folks’ heads. And Robert Lucas has shown (pdf) that the average costs of economic fluctuations are small and can in principle in shared by using better markets in risk - which Shiller’s own superb work has helped demonstrate.
What’s more, given that the private benefits of innovation are low, and the probabilities of success in many arts and industry small, it might be only animal spirits that give us artists and entrepreneurs. As Richard Nisbett and Less Ross wrote years ago:
We probably would have few novelists, actors or scientists if all potential aspirants to these careers took action based on a normatively justifiable probability of success. We might also have few new products, new medical procedures, new political movements or new scientific theories.
Perhaps, then, it’s not just that animal spirits are ubiquitous - but they are necessary too.
I have always questioned the thought process behind the mod mentality in these ort of times. I distinctly remember Princess Diana being heavily criticised for spending in the last recession. Never made sense to me. In a recession those with the money should spend and lot's, and should be encouraged to do so. Criticising people for doing exactly what we all need is a terrible approach. The popular media has alwyas been particularly guilty of this approach
Posted by: vj angelo | February 26, 2009 at 01:48 PM
I really like your last points, that things like invention and entrepreneurship need not be rational in the narrow sense. That Carroll paper looks very interesting too.
Posted by: Luis Enrique | February 26, 2009 at 02:19 PM
I've always believed that genius ( of whatever kind) relies heavily on "outliers". You can't teach genius - its the leap in understanding or ability. Lots of people of genius have quirks - think of George best and Gazza in football, or Van Gogh in painting - all slightly outwith the normal. But without that quirk gene ( self destruction here) would they have had genius? I doubt it
Posted by: kinglear | February 26, 2009 at 02:30 PM
The tendency of Economics to make a meal of the most commonplace observations on life is such rib-tickling fun.
Posted by: dearieme | February 26, 2009 at 03:34 PM
Sounds to me like swarm intelligence.
First there is a spread of resources, this is the only tool the swarm has to start with, (its irrational start point) to look for the weak point, when the weak point is found there is a convergence and the weak point is opened up to a wider and bigger access.
And it worked both ways in the current unpleasantness, we had one swarm on the inside pushing the weak points out and the wall of money (directed by another swarm of people) coming in the other side finding its way to those weak points.
Posted by: Danny The Dog | February 26, 2009 at 06:19 PM
A lovely post.
Looking back, I liked Patrick Minford's piece just because it began to formalise what had seemed common sense.
Apart from changes in the likelihoods of future events, both epidemic spread of expectations based on incomplete information, or plain incompleteness of information in the Austrian style, can lead to the piles of assets that can only be sold below valuation/claims that cannot be collected in full which make a recession inevitable. Does not "animal spirits" as such get knocked out by Ockham's razor?
Posted by: D iversity | February 26, 2009 at 08:03 PM
Why do you think Steve Gerrards won't have fallen? I could make a perfectly good argument that it has (what will he do when he no longer plays - probably be a talking head on TV or a football manager - and a fall in potential advertising revenue will reduce the pay for both those jobs).
Posted by: reason | February 27, 2009 at 11:10 AM
oops
... Steve Gerrard's permanent income ...
Posted by: reason | February 27, 2009 at 11:11 AM
Not sure you've used a good example here. He's got every reason to worry about his permanent income.
According to Sport magazine Stephen Gerrard has invested heavily in new luxury property development over the last two years - as per Arsenal he's probably up shit creek on those investments in the short term.
Posted by: Rohan | February 27, 2009 at 02:12 PM
Pointing out things that conventional economics gets fundamentally wrong is like fishing in a barrel, and lately it's started to feel a bit like kicking somebody when they're down. However, another dimension of whether the ubiquity of animal spirits is really a bad (or even an irrational) thing is that "animal spirits" ultimately refers to behaviors which have proven empirically successful over a very long run.
It's only recently, maybe 30-50 years depending on where you start counting, that we've had any theoretical tools to even describe what the rational origins of that behavior might be. Only 150 years since we figured out that there might even *be* any rational, rather than theological, origins in the first place.
The classic and trivial example is the difference between iterated and non-iterated prisoner's dilemma. But the general principle -- that behavior which is non-maximizing for a single agent in a finite game can be hugely advantageous for a population of agents in a non-finite game -- turns out to be very broadly applicable.
Posted by: radish | March 01, 2009 at 08:03 PM
Daniel Gross has shown that bubbles leave a benign legacy; those condos in Miami may be worth only a fraction of what they cost, but they put roofs over folks’ heads
Always keep focused on the opportunity costs.
Posted by: TGGP | March 08, 2009 at 08:02 AM
The tendency of Economics to make a meal of the most commonplace observations on life is such rib-tickling fun.
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