Animal spirits:

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    The roles played by psychological factors in the business cycle and in economic development are emphasized by George A. Akerlof and Robert J. Shiller in "Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism."
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Keynesians practically abandoned the animal spirits aspect of Keynes' theory, leaving them without an accurate concept of the business cycle.

  John M. Keynes highlighted this view in 1936 in "The General Theory of Employment, Interest and Money," they point out, but Keynesians practically abandoned this aspect of Keynes' theory, leaving them without an accurate concept of the business cycle.

  This is a very embarrassing weakness, since mitigating the business cycle is precisely what Keynes and his followers claim to be doing. Their total inability to forecast the business cycle is a constant embarrassment for them. Their ridiculous - clearly self serving - response is that the business cycle cannot be accurately forecast by anyone. Instead, Keynesians proffer "projections" that are works of fiction since they never survive the next sharp turn in the business cycle. See, Hendry & Ericsson, "Understanding Economic Forecasts."

The complex psychological elements that underlie "animal spirits"  are obviously powerful - outcome determinative - factors in the waxing and waning of the business cycle and in the course of economic development.

  The authors are clearly correct. The complex psychological elements that underlie "animal spirits"  are obviously powerful - outcome determinative - factors in the waxing and waning of the business cycle and in the course of economic development. They correctly emphasize the importance of confidence and trust, various alarms and fears, and "stories people tell about their lives today and in the future." For purposes of analysis, the authors gather them under the headings of "confidence," "fairness," "corruption," "money illusion," and "stories."

  "Insofar as animal spirits exist in the everyday economy, a description of how the economy really works must consider those animal spirits. That is the aim of this book."

  FUTURECASTS is overjoyed that establishment economists are finally recognizing this important weakness in standard economic theory. The same criticism is raised by Baumol, Litan and Schramm, in " Good Capitalism, Bad Capitalism."
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  Indeed, FUTURECASTS has been emphasizing this weakness since its second volume in 1999. See, Capital as Purchasing Power. The publisher of FUTURECASTS has been emphasizing this weakness since 1967 in his presciently entitled book, "Dollar Devaluation." Recognition of this and the many other weaknesses in Keynesian theory and policy have provided one of the bases for the publisher's 40 years of accurate published economic forecasts. During that period, Keynesian economists shifted from the assertion of scientific certitude in the 1960s to their current admission of complete incompetence at economic forecasting.
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  Thus, although it contains a plethora of the weaknesses to be expected in a book by two Keynesian economists, FUTURECASTS supports the authors' views about animal spirits and highly recommends their book.

  The authors grieve "the steady emasculation of Keynes' General Theory." They point out, correctly, that the conservative revolution under Ronald Reagan and Margaret Thatcher that rose out of the Keynesian ashes of the 1970s Great Inflation also neglected to account for important psychological factors. 

  "No limits were set to the excesses of Wall Street. It got wildly drunk. And now the world must face the consequences."

Confidence:

  The nature of economic "confidence" and its impacts in economic systems is explained by the authors.
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The waxing and waning of confidence plays a major role in the waxing and waning of the purchasing power of credit and capital and the willingness to commit that purchasing power at various levels of risk.

The confidence multiplier cannot be measured like other factors included in econometric models.

  Confidence is an inherently unstable psychological factor, as the authors emphasize.

  Unfortunately, the authors do not explain the many fundamental factors on which confidence is based and which provide it with impressive levels of stability and resiliency over the course of the business cycle. They emphasize the irrational and ignore the rational aspects. American optimism is based on centuries of progress and a flexible market economic system that works and is naturally resilient within its business cycle. Only government policies of incredible stupidity that constrain market mechanisms can destroy that natural resiliency, as occurred during the Great Depression of the 1930s and the Great Inflation of the 1970s. See, Summaries of Great Depression Controversies and Facts, and the six Great Depression Chronology articles beginning with The Crash of '29, In the U.S., as David S. Landes points out in "The Wealth & Poverty of Nations," "In the long run, only optimism pays."

  The authors provide a "multiplier" explanation for the simple fact that the waxing and waning of confidence plays a major role in the waxing and waning of the purchasing power of credit and capital and the willingness to commit that purchasing power at various levels of risk. They candidly recognize that the confidence multiplier cannot be measured like the consumption, investment and government expenditure multipliers for use in econometric models. They assert that adverse changes in confidence levels provide an explanation why Keynesian stimulation so frequently fails to have the promised impacts during economic contractions.

  The search engine in the left hand frame of its Homepage comes up with over 30 references to "confidence" used in an economic context in FUTURECASTS during the last decade.

Fairness:

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  Expectations of fair conduct are widely recognized in various academic fields, including economics, but the impacts of such expectations generally are given only minimal consideration by economists.
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 The authors note a variety of sociological and economic experiments that demonstrate such impacts. They assert that various market failures, such as the relation between inflation and aggregate output and the rigidity of labor markets that causes chronic involuntary unemployment can only be explained if fairness factors are taken into account.

  The search engine in the left hand frame of its Homepage comes up with about 10 references in FUTURECASTS to "rigid" labor and other economic markets. The authors gather the psychological factors that play a role in making markets rigid under their "fairness" category.

Corruption and bad faith:

  Modern financial mechanisms are inherently dependent on trust. Every day, the authors emphasize, people put their savings and investments into the hands of others on the basis of trust in the intentions of the recipients.
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Accounting is one of man's more nebulous practical arts. The temptations for creative accounting can be great, and nothing undermines trust in a system like the occasional implosions caused by creative accounting.

Business cycle contractions expose these houses of cards, Ponzi schemes and other scams.

  Hundreds of billions of dollars flow through financial systems every day on the basis of nothing more than phone calls or computer clicks and established patterns of conduct. Mere pieces of paper or notations in accounts are all that is received in return until yields or returns are realized.

  It is thus arguable, contrary to standard anti-capitalist propaganda, that capitalism is the most ethical economic system ever established. It clearly can't function without trust. Scams and fraud succeed precisely because they occur in so small a minority of transactions and thus catch people completely off guard. The search engine in the left hand frame of its Homepage comes up with about 11 references in FUTURECASTS to "trust" as a vital factor for capitalist markets.

  The books and records and reports generated by accountants provide the essential foundations for trust and expectations. However, accounting is one of man's more nebulous practical arts. The temptations for creative accounting can be great, and nothing undermines trust in a system like the occasional implosions caused by creative accounting. The authors compare those who take advantage of creative accounting to the snake oil salesmen of the 19th century. There are a variety of ways to milk the assets of an entity and/or sell it off to unsuspecting purchasers.
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  Business cycle contractions expose these houses of cards, Ponzi schemes and other scams. (The business cycle in its vicious way repeatedly proves far more effective at cleansing the system than the regulators.) When these schemes collapse, sometimes spectacularly, they add to the miseries of the economic contraction. The authors discuss several examples from the last three economic contractions.

  "Corruption scandals are always tremendously complicated. Yet they are also tremendously simple. They are simple because they always involve the violation of elementary principles of accounting regarding how much money can legitimately be taken. They are complicated precisely because the participants seek to shroud in complexity the violation of these simple principles."

  The role of government in the savings and loan association collapses and their connection to the 1990-1991 recession are candidly explained by the authors. Inflation and rising interest costs had reduced the value of the long term fixed rate mortgages held by the S&Ls to the point where the banks were insolvent. The politicians would have found this hugely embarrassing since they were responsible for the applicable regulatory regime that constrained the S&Ls and the inflation that pushed interest rates so high. Thus, they permitted creative accounting to cover the problem and authorized the S&Ls to engage in a wide array of speculative investments in the hope they could work their way out of their problems.

  This was a bipartisan effort. A $20 billion problem was kicked down the road until it became a $140 billion problem, after which it was swept under the rug - financed off budget - at a cost in excess of $200 billion. That's your government in action, the government that's going to be running your health care industry.

  Desperately hoping to survive, S&Ls became heavily involved in the excesses of the 1980s, including the junk bond market developed by Michael Milken, the surge in hostile takeovers, the massive increase in corporate leverage and corporate compensation for top executives, and a real estate boom and bust. The loss of confidence as these activities unraveled played a major role in the 1990-1991 recession and the two years of slow recovery thereafter.

  The junk bond market has proven tremendously productive for smaller corporations and the development of entrepreneurial corporations, but like any credit instrument, abuse is an attractive option and was initially widespread. In the nature of the beast, there will be extensive blood letting in the junk bond market during every business contraction. They are not for the faint of heart. 

  These events undermined public confidence in the overall fairness of the financial markets, the authors assert. Nevertheless, that didn't discourage the dot-com bubble that burst during the 2001 recession, nor did it warn people away from the even bigger scandals swept away by that recession. Again the authors assert a loss of confidence, but go on to relate the even bigger scandals and houses of cards erected thereafter to be swept away in the 2007-2009 credit crunch recession.
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Unsurprisingly, the regulators missed a wide variety of scandals and houses of cards built with overextended credit, all of which have been thankfully revealed and swept away by the business cycle contractions.

  The authors explain the Enron scandal. Unsurprisingly, the regulators missed a wide variety of scandals and houses of cards built with overextended credit, all of which have been thankfully revealed and swept away by the business cycle contractions. They all "undermine confidence," the authors lament, but that skepticism never seems sufficient to discourage the erection of even bigger houses of cards during subsequent economic expansions.

  "People became fed up with financial markets in general, and this attitude inhibited the economy far more than any other exogenous factor one can imagine operating at the time. That people were reacting to the corruption and bad faith in the financial markets, and desiring to withdraw from them to such alternative investments as real estate, is apparent in the responses to the questionnaires that Karl Case and [Shiller] have regularly sent out to individual and institutional investors since 1989. Investors in 2001 told us in no uncertain terms that the accounting scandals were a major factor in their withdrawal from the stock market, and also a reason for their newfound faith in the housing market. In the housing market they did not need to trust the accountants."

  Then came the bubbles in housing, mortgage backed securities, and a wide variety of other collateralized debt obligations that burst during the Great Deleveraging  or Credit Crunch recession that began in 2007. The authors provide a brief description of this boom and bust of the credit bubble mania, involving conflicts of interest at multiple financial stages.

  Unfortunately, the authors omit the government's role in creating the moral hazard phenomenon that played a major role in the process. See, "Moral Hazard & Conflicts of Interest in Credit Crunch," and Tavakoli, "Dear Mr. Buffett," emphasizing that the Credit Crunch cannot be explained or its problems adequately remedied without taking into account the regulatory failures and Congressional mismanagement involved. Cooper, "The Origin of Financial Crises," explains the massive role of  central banks, especially the Federal Reserve Bank, and the mismanagement of monetary policy in generating financial crises, particularly including the Credit Crunch.

These surges and collapses of scandals and public confidence are psychological factors that economists rarely concern themselves with. Economists should take them into account, since they observably play a role in the business cycle.

  The waxing and waning of corrupt practices corresponding to the waxing and waning of recent business cycles are emphasized by the authors. During the boom phase before each bust, opportunities for corrupt practices - for the sale of financial snake oil - proliferate, and there are always those willing to take advantage of public credulity. These surges and collapses of scandals and public confidence are psychological factors that economists rarely concern themselves with. The authors insist convincingly that the economists should take them into account, since they observably play a role in the business cycle.

  However, modern economists hate such factors. Psychological factors cannot be expressed as an equation, cannot be included in econometric models, and cannot be dealt with by mathematical forms of economic analysis. The most influential economists have reduced themselves to mere technicians who accept the limits of mathematical forms of economic analysis to maintain a false pretense of scientific "rigor." Mathematical models are just skeletons of reality, and macroeconomic models never match the live economic body they claim to represent. They match a fictitious dead economic world. Instead of "rigor," these economists afflict themselves with "rigor mortise" that deadens their senses to the real live economic world.

Money illusion:

  The impacts of inflation were notoriously disregarded prior to the Great Inflation of the 1970s. Except during periods of major conflict or gold rush, price inflation had been merely cyclical in the U.S. as it prospered mightily and rose to great economic power status prior to the Great Inflation.
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  That all changed with the New Deal and WW-II. However, it took another generation for people to begin to dispel the "money illusion" that prices were stable within the business cycle and that a dollar was a dollar. Most people continued to base their economic decisions on nominal value, without regard to the declining real value - the declining purchasing power  - of the dollar. Even economists mostly disregarded the impact of inflation prior to the 1970s.
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  The change began in the 1960s. The authors tell of how the 1970s brought the demise of money illusion concepts and the "Phillips Curve" notion that there was a natural tradeoff between inflation and unemployment. During the 1970s, inflation and unemployment both rose together (as they always ultimately had in countless instances throughout economic history).
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The authors assert reasonably that "natural unemployment rate" theory is now so widely used by economic policy makers throughout the developed world that it should be subjected to extensive testing. This has not occurred. Yet instances of money illusion keep popping up widely within the economic system.

  A new theory of "inflationary expectations" was advocated by Milton Friedman. It undermined the Phillips Curve. It stressed that there was only one "natural rate of unemployment" that would be price neutral. Economic policy should be content with stabilizing the economy at this natural rate. Any attempt to reduce unemployment further would lead to price inflation rates that could not be stabilized. Inflation expectations would ratchet wages and prices continuously higher - as in the 1970s. Econometric analyses seemed to support Friedman's concepts, but (as usual) they were inherently imprecise. They ignored "economically significant differences" from natural rate theory.
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  The authors accept the notion that the "money illusion" concepts of prior economists like Irving Fisher and Keynes were oversimplified and naïve. However, they reject the total abandonment of the concept. They consider the rigid acceptance of natural unemployment rate theory without any regard to money illusion equally oversimplified and naïve. The authors assert reasonably that "natural unemployment rate" theory is now so widely used by economic policy makers throughout the developed world that it should be subjected to extensive testing. This has not occurred. Yet instances of money illusion keep popping up widely within the economic system.
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  Inflation adjustments are actually not widely used in commercial and labor contracts. Even those contracts that contain inflation adjustment provisions usually provide less than full protection. Nominal values still provide the basis for most annual agreements even when prices are fluctuating fairly sharply. In the other direction, resistance to wage cuts during the rapid deflation of the 1930s was notorious.
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  Even long term bonds and mortgages are based on nominal values. The real value of the principal declines over time with inflation, and the interest rates charged are generally insufficient to make up for the difference.

  "Once again, given that so much contracting is done in money terms, it seems unlikely that money is just a veil."

  More important, accountants keep books and records in nominal; terms and issue financial reports from them on which managers and financial markets depend. All decisions made by managers and investors and financial institutions thus suffer from money illusion.

  During the 1970s, as price inflation accelerated, price/earnings multiples declined.  The markets became increasingly aware that the "quality" of reported earnings was declining. Accountants shifted from FIFO to LIFO inventory accounting and in other ways attempted to adjust for inflation - if only to avoid paying taxes on illusory nominal "earnings." The markets were not as unaware of real values as the authors imply. Long term interest rates rising into double digits, the emphasis on speed at the expense of quality on construction projects, and numerous other phenomena indicate the limits of money illusion. Nevertheless, some money illusion undoubtedly continued even in the 1970s.

  The authors correctly point out that such adjustments fell considerably short of dispelling all money illusion impacts.

  "We shall see that taking money illusion into account gives us a different macroeconomics -- one that arrives at considerably different policy conclusions. Once again animal spirits play a role in how the economy works."

Panic and overconfidence:

  There are observable economic and financial impacts as confidence waxes and wanes. Indeed, when these psychological shifts become extreme - during periods of exuberance or panic - the economic and financial impacts become notorious. Yet many economists ignore these observable phenomena in their analyses of the economy.
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People construct stories that explain reality and rely on them in the conduct of their lives. When reality fails to conform to an accepted story, people are incredulous - then disillusioned. Explanations of the business cycle are impossible without understanding this psychological phenomenon.

  These psychological swings are related by the authors to the human tendency to put experiences into story format. People construct stories that explain reality and rely on them in the conduct of their lives.. When reality fails to conform to an accepted story, people are incredulous - then disillusioned. Explanations of the business cycle are impossible without understanding this psychological phenomenon.
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  The authors emphasize "new era" stories that keep popping up to support periods of booming growth and exuberance that ultimately always involve the assumption of unjustifiable credit risks. The internet was the basis for the "irrational exuberance" of the dot-com boom before the panic of the 2000-2001 dot-com bust.

  "Confidence is not just the emotional state of an individual. It is a view of other people's confidence, and of other people's perceptions of other people's confidence. It is also a view of the world -- a popular model of current events, a public understanding of the mechanism of economic change as informed by the new media and by popular discussions. High confidence tends to be associated with inspirational stories about new business initiatives, tales of how others are getting rich. New era stories have tended to accompany the major booms in stock markets around the world."

  Business cycle history is inexplicable without reference to such stories, and the tendency to forget them leaves us mystified as to the causes of business cycle swings.
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  Confidence waxes and wanes - with periods of sober optimism sometimes developing into periods of exuberance followed by periods of fear and sometimes moments of panic. These moods spread much like virulent epidemics. The contagion rate may be mild one minute and explosive the next due to a multitude of factors.
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Great depressions:

  The role of psychological factors in two great depressions - during the 1890s and 1930s - is emphasized by the authors.
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There were of course fundamental factors involved that economists have since analyzed with varying degrees of perceptiveness, but the actual course of events can't be validly and convincingly analyzed without consideration of the psychological factors emphasized by the authors.

  "New era" stories initially proliferated during a period of prosperity. Exuberance and panic accompanied boom and bust. With the onset of economic contraction, a sense of unfairness spread as greed and corruption were exposed by collapsing embezzlement and Ponzi schemes. Innumerable houses of cards built on overextended credit collapsed and money illusion led workers to fight bitterly against wage reductions that were less than the general price deflation. Despondency replaced confidence as the economy failed to recover.

  "When the market collapsed after 1929 the stories changed completely. The economies of major countries around the world fell into deep depression, and the stories turned to unfairness, corruption, and deception."

  There were of course fundamental factors involved that economists have since analyzed with varying degrees of perceptiveness, but the actual course of events can't be validly and convincingly analyzed without consideration of the psychological factors emphasized by the authors.

  Unfortunately, the authors embellish their otherwise convincing arguments by playing fast and loose with some pertinent facts. This book should thus not be used as authority for any of the historic facts related. For example:

• The authors falsely assert that stock markets were booming "around the world" in 1929. Most European markets were in fact notoriously lackluster and fell into decline as the year progressed months before the October Crash in New York. By the summer of 1929, much of Europe was already in depression. As the authors themselves recognize, unemployment was already in double digits in Germany in October 1929.
• The authors assert that the Great Depression was caused by the stock market Crash of '29. This contention went out of fashion decades ago, and is clearly absurd. Economic contraction became widespread in the U.S. from the middle of August 1929 while the stock market was booming, and the causes can be clearly traced back into the previous booming seven months.
• The authors assert that the related banking crisis was a major factor in initiating the Depression, but the crisis in banking didn't reach serious proportions until a year after the Crash and played no role in the failure of the substantial spring 1930 economic and financial rebound.
• The authors assert that public and professional psychology turned immediately negative with the '29 Crash. However, both authoritative and investor spirits remained high through the substantial spring 1930 economic and stock market rebound. In that era before high marginal tax rates, dividend yields were an important part of return on investment. Until the fall of 1930, yields on the major stock market indices remained at low levels indicating that investors were still relying on rapid recovery to justify their investments. Prominent economist Irving Fisher and N.Y. Times columnist Alexander Noyes, both of whom the authors cite with approval, remained confident of rapid recovery for more than two years after the Crash. The stock market was like a loaded spring throughout the Great Depression, repeatedly surging rapidly upwards with any substantial indications that recovery was at hand, as in the corn drought rally of the summer of 1930, the Hoover Moratorium rally of the summer of 1931, and the spectacular summer rally during 1932 when record small crops caused a surge in agricultural prices.
• The authors correctly note the role played by the breakdown of the gold standard mechanism in spreading calamity worldwide, but they offer no word about the protectionist and monetary policies of the U.S. Government that were the primary causes of that breakdown. Passing over this aspect of the story with the simplistic statement that its "time had passed" is clearly inadequate.

Money illusion was evident in the resistance to wage cuts, which substantially trailed deflation rates through the first years of the Great Depression. Real wages continued to rise throughout the decade. For those who had and kept their jobs, the 1930s were a period of abundance.

  Psychological factors clearly played prominent roles in the Great Depression. A sense of unfairness contributed to labor unrest worldwide and a surge of popularity for communist and socialist alternatives. Fear as to both political stability and the lack of economic resiliency afflicted business plans. Money illusion was evident in the resistance to wage cuts, which substantially trailed deflation rates through the first years of the Great Depression. Real wages continued to rise throughout the decade. For many of those who had and kept their jobs, the 1930s were a period of abundance.
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  As the decade wore on, observers noted a spreading and deepening of what today is called "public malaise." Most obviously, psychological factors - emotions and propaganda based generally on fairness claims - generated vast public support for the New Deal experiments, both the successes and the failures.

  "In the Depression, confidence was so shattered that banks were holding vast unlent sums, and businesses did not want to invest in new capital even though interest rates were at abnormally low levels. In such a situation, no policy regarding nominal wages - either to increase them or to decrease them - would address this fundamental problem. General loss of confidence was the main cause of the loss of demand, and thus the low level of employment. Real fears about the future of capitalism itself were one component of this loss of confidence, which prolonged the Depression."

  Loss of confidence was a secondary cause, not a primary cause, of the failure to recover during the Great Depression. For the first two years, there was a plethora of authoritative voices employed to boost "confidence" to bring the Great Depression to an end, but confidence that rests on nothing leads only to disillusion and the ultimate loss of credibility for the authoritative voices. Until the fundamental causes were addressed, psychological problems could not be successfully addressed.
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  Nothing could work until the nation's vast agricultural sector and important mining and manufacturing sectors could regain vital international markets. WW-II in Europe opened world markets to American exports, thus bringing the Great Depression to an end many months before U.S. entry into WW-II and the initiation of the vast WW-II deficits.

  Indeed, the role of confidence is presented as a primary factor in the Great Depression., They assert that both the 1890s and 1930s depressions "were intimately linked with these hard-to-measure variables" encompassed within the term "confidence."

  Of course, "confidence" in the business sense is just the standard evaluation of the "risk" factor in the traditional business and investor analysis of risk and reward. As such, it is not overlooked. Indeed, it is omnipresent - but not for mathematical economics.

  The authors overall conclusion, stripped of some excessive elaboration, is clearly correct. Human nature must be a primary factor in economic analysis, even if it involves "hard-to-measure variables" that mathematical economists prefer to ignore.

  "People are still every bit as concerned about fairness, still vulnerable to the temptations of corruption, still repulsed when others are revealed in their evil deeds, still confused by inflation, still dominated in their thinking by empty stories rather than economic reasoning. Events like the two depressions we have just described cannot be counted as things of the past."

  The authors stretch their point too far when they assert that a return of the Great Depression awaits only some collapse of confidence. As stated above, only government policies of incredible stupidity can undermine the powerful recuperative powers - the natural resiliency - of capitalist markets. There were many such policies during the Great Depression. Psychological factors are important intermediate economic factors, but they are always dependent on other factors that are primary.

Lender of last resort:

  In a brief review of monetary policy, the authors explain how the Federal Reserve System adjusts the money supply and influences interest rates to stabilize the economy.
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  It is as lender of last resort that the Fed confronts a primary psychological factor - the panic of bank runs. By being ready to lend on good collateral, the central bank prevents good banks with good but temporarily illiquid collateral from being carried away with the bad. (Policy response to the Credit Crunch has moved way beyond this traditional role.)
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  Deposit insurance was added by the New Deal to further support confidence in the banking system and prevent bank panic and bank runs, and a mechanism was provided through the Federal Deposit Insurance Administration for the orderly winding up of insolvent banks. Covered banks had to submit to regulatory supervision to prevent abuse of these advantages that might place deposit insurance funds too much at risk.
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  However, there are always aggressive participants in the markets whose "animal spirits" impel them to take greater risks than regulatory supervision would allow. They choose to work in much the same manner as banks but outside the regulated sphere. They form investment banks, bank holding companies and hedge funds that raise funds from investors and creditors rather than from depositors. Unfortunately, as occurred during the Credit Crunch of 2007-2009, these non-depository "non-bank" banks are just as subject to panics and runs  as banks are. Their creditors can react to panic like depositors and cut off credit lines or refuse to renew short-term credit. Moreover, they can reach sufficient size and involvement in the financial system so that collapse can threaten systemic collapse in the regulated as well as the unregulated financial system.
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  Then, in September, 2008, the Fed and Treasury let Lehman Brothers investment bank go into bankruptcy to wind up its affairs. Suddenly, systemic panic became a reality.
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A Keynesian cure:

 The authors propose a Keynesian cure. They are, after all, admirers of John M. Keynes.
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Bailout support should be extensive enough to restore "full employment," the standard Keynesian target.

  Not only must the deficit spending be huge, but monetary policy must support financial activity at levels consistent with full employment. Having criticized macroeconomic models for omitting a host of important variables, they nevertheless express confidence that these models can accurately predict the budgetary and monetary amounts needed and the impacts of such policies.

  However, macroeconomic models are notoriously unreliable at predicting anything not moving in a straight line. They only "project" straight line results based on the fallible assumptions of the mathematical economists. They are thus not very useful in turbulent times.

  The authors view the Credit Crunch as essentially a financial system collapse. Important financial entities have indeed collapsed, leaving gaping holes. Others are near collapse and burdened with toxic assets requiring bailouts and support to restore lending activities. The authors assert that this support should be extensive enough to restore "full employment," the standard Keynesian target.
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  The authors leave it up to the econometric modelers to calculate the sums involved, and thus do not deign to offer even estimates. They admit they are talking about huge sums. The sums committed at the end of 2008 - more than two trillion dollars in monetary expansion and Treasury stimulus spending - is clearly for them just a good beginning.

  Unfortunately, the authors have misdiagnosed the problem. The Credit Crunch certainly involves the financial system, but it is essentially an inventory accumulation problem - such as occurred in the 1920-1921 depression. Unfortunately, a housing inventory surplus is much more difficult and takes much longer to work down than merchandise or supply inventories. Two trillion in stimulus and credit system support has importantly stabilized the financial system and mitigated the housing market collapse, but it has not prevented the development of the recession or the increase in unemployment, now approaching 10%. Helped by government mitigation efforts, the markets are moving quickly in their usual ruthless manner to liquidate the problem, but unemployment will continue to increase until the market reduces housing inventories back towards normal levels.
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  Meanwhile, even as the recession bottoms out, most of the stimulus funds remain unspent - available fortuitously to support the election campaigns of incumbent politicians in 2010 when the economy will already be in recovery.
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  Keynesians assert that the Credit Crunch would have been even worse if not for the Keynesian response. It would certainly have been remarkable if over $2 trillion did not achieve some substantial mitigation. However, vast Keynesian  monetary expansion and stimulus spending has yet again failed to prevent or even materially shorten an economic contraction. Keynesians will complain that the stimulus deficits and monetary inflation - as big as they were - were not nearly enough. They never are!
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  Mere mitigation is not what Keynesians claim for their policies. Mitigation alone hardly justifies the vast increase in the nation's debt burden. These policies will inevitably leave huge debts to burden the future and massive expansion of the money supply that will have to be withdrawn to prevent a major surge in price inflation.
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  In practice, Keynesian debts never get paid  off. This will not, after all, be the last business cycle contraction. How much further into debt will the nation have to go to deal with the next one - and the one after that? Nor do we just "owe it to ourselves." Japan has been employing Keynesian stimulus for two decades without success. Its national debt now approaches 200% of GDP, and its population is aging fast. With monetary inflation causing an increase in financial instability and an acceleration of the business cycle, the U.S. could quickly find itself in the same boat.
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  The authors advocate Keynesian policies, citing their apparent success for the two decades after WW-II. They ignore the fact that the dollar during those two decades was supported by a vast hoard of monetary gold and sales to a war-torn world. However, that gold hoard was exhausted during those two decades, Europe and Japan rebuilt, and the dollar is now on its own.
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  Keynesian stabilization policies succeed in mitigating economic contractions, to the extent that they work at all, only so long as the currency stays strong. Unfortunately, Keynesian policies tend to undermine the currency. That's why so many nations with less sturdy currencies refuse to apply Keynesian policies to the extent Keynesians believe are needed. See, Keynes, "The General Theory," Part I, "Elements of the General Theory" and Part II, Interest Rates, Aggregate Demand & the Business Cycle."

Involuntary unemployment:

  Why don't labor markets clear like other markets? The authors answer this very appropriate question with the "efficiency wage theory," developed in the 1980s and still far from universally accepted.
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The perception of fairness in the wage offered will have an impact on how willingly labor is provided once it is offered, and how loyally it is continued.

There is obviously more to the cost of labor than just wages and benefits. Retention rates, quality and reliability are among the obvious factors that also count.

  Employers are frequently concerned with quality of labor, not just quantity. They may also be concerned with retention rates. The perception of fairness in the wage offered will have an impact on how willingly labor is provided once it is offered, and how loyally it is continued.

  This is not really remarkable. It applies to all services. If they can afford it, people do not seek the cheapest doctor - or plumber or electrician, either. Variety and quality are additional factors that are not well handled by mathematical economists and macroeconomic econometric models.

  Thus, wages offered during business contractions generally remain above market clearing levels, and work offered at that rate is insufficient to employ all labor being offered.
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  The authors emphasize that there is wide variation in the prices charged for goods in the same city. Sometimes the variances are considerable. The authors found a median difference between high and low for 39 items was 157%. (Retailers vary in the use of reduced price sales as a marketing tactic.) Wages vary, too, even for jobs that require similar skills. The authors control for skills, job conditions, experience and other factors and still find considerable variance in what different employers pay for similar work. The authors don't mention benefits but do mention seniority rights and reputation.
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  But why aren't there some employers willing to try to get a competitive advantage by offering lower wages to the unemployed? There is obviously more to the cost of labor than just wages and benefits. Retention rates, quality and reliability are among the obvious factors that also count.
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For both worker and employer, the perception of fairness in wages and working conditions and total compensation has value, and this can keep compensation above labor market clearing levels.

  Most workers take pride in their jobs and are satisfied and loyal, according to surveys referred to by the authors. Thus, most must think that they are being fairly paid.

  This is the standard magic of the market. Both sellers and buyers come away from most exchanges feeling they have obtained more from the exchange than they have given. Some employees, like steel workers, are attracted to the most dangerous and difficult jobs, and want them on their résumés. This is just one of the many psychological factors involved in the labor market.

  Thus, for both worker and employer, the perception of fairness in wages and working conditions and total compensation has value, and this can keep compensation above labor market clearing levels.

  The cost of labor is higher than the wage offered. There are total compensation costs, including benefits. Health care and pension benefits may appear to be of little value to younger workers, creating a wide gap in the labor market model. Amazingly, the authors neglect the impacts of payroll, unemployment insurance and withholding taxes and minimum wage requirements. There are also labor market costs that do not benefit any worker. These include union work rules and other burdens, legal liability risks and regulatory costs.
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  The authors do not deign to consider such factors. However, such factors render labor markets notoriously imperfect, so it should not be such a puzzle why they don't clear at "full employment" levels. Of course, such factors were far less present during the first half of the Great Depression.

  Money illusion is most dramatically demonstrated by the reluctance to impose or take wage cuts even in periods of substantial deflation. Even in those extreme deflationary periods when wages are cut, they are cut late and less than the deflation. They are "sticky" in a downwards direction. They are "downwardly rigid." Wage cuts are widely perceived as "unfair" and will undermine worker loyalty unless clearly needed to save the business.
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  The authors justify 2% inflation rates with econometric analyses and Phillips curve calculations.

  Modern economists looking for answers in macroeconomic econometric models are like ancient priests searching for omens in the entrails of a pig. They repeatedly find what is favorable for their political or ideological interests.

  The authors denigrate the widespread public unease about continuous low levels of inflation. Economists expect wages and other factors to rise relatively  smoothly upwards to keep pace with and neutralize modest inflation rates, but the general public has profound doubts. Poor, ignorant masses. They suffer from money illusion. They think in terms of nominal wages and prices instead of real wages and prices.

  The authors do not deign to discuss the difficulty of keeping inflation rates at and below 2%, and the many ways in which inflation does real damage and imposes real burdens on the economy. They do not discuss the value drawn from the economy by the monetary inflation tax. Why shouldn't the poor ignorant masses object to the burdens of the money inflation tax just as they do any other tax? See, "Understanding Inflation," and Capital as Purchasing Power." It is, after all, one of the most regressive ways of raising revenue imaginable.

   Phillips curve relationships are not as immutable as sometimes asserted. The authors are skeptical that wages and prices reflect inflation expectations precisely - especially in the usual case of low levels of inflation. Thus they accept uncertainty concerning the impact of inflation on Phillips curve calculations.
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The authors threaten that there will be about 2 million additional unemployed if the nation does not accept about a 2% inflation rate. They fend off opponents of this strange Keynesian assertion with an ad hominem attack, asserting the opponents are the "ideologues."

  The authors employ scare tactics to support Keynesian assertions. Like clerics threatening non-believers with hell and damnation, they threaten that there will be about 2 million additional unemployed if the nation does not accept the approximately 2% inflation rate that Keynesians support. They fend off opponents of this strange Keynesian assertion with an ad hominem attack, asserting the opponents are the "ideologues." (Keynesians once claimed to be practically "scientific," an absurd claim that revealed Keynesians to be the ideologues.) They assert that tight monetary policies caused high unemployment in Canada in the 1990s, but offer no analysis. They provide Keynesian interpretations of dubious validity of historic events to prove Keynesian concepts. 

  Price inflation, even at low rates, results in a steady loss of purchasing power that can only be made up by a more rapid increase in the money supply. The monetary inflation is a tax on the economy that provides revenues for political use that the politicians love. Keynesians ardently support the political desire for as much of this revenue stream as they can get away with.

  Price deflation, on the other hand, is an economic stimulant that increases purchasing power and is a proven cure for business cycle contractions - unless an economy has dangerous levels of debt - which is an inevitable consequence of decades of Keynesian policy. Only during the Great Depression, when government policies destroyed international markets and then imposed heavy economic burdens on enterprise, did deflation fail to stimulate economic recovery. See, Meltzer, "History of Federal Reserve, vol. 1, Part I, at segment on "The depression of 1920-21." But deflation's benefits accrue directly to the people. It provides no revenue for the politicians, so Keynesians hate it.

Savings:

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  The propensity to save is a psychological factor that clearly has important economic impacts.

  However, the Keynesian notion that an increase in savings can bring a period of prosperity to an end and initiate a recession is clearly ridiculous. Serious economic contractions cause unused savings, no economic contraction has ever been initiated by unused savings.

  Young people seem incapable of rationally evaluating the benefits of saving and investing today at compound interest for retirement benefits in a future too distant for them to take seriously. This includes young economics  assistant professors at Harvard. The propensity to save depends as much on animal spirits as economic calculation. The current standard economic theory of saving has many uses but does not adequately address the variability of savings rates nationally, individually, socially, chronologically, institutionally, and in regard to changing situations. A variety of social "cues" affect savings decisions, and these can be quite fickle. Students frequently think it odd to be thinking of retirement before their earning lives have even begun.

  "Generalizing from [experiments with students], it is clear that context and point of view are crucially important in determining saving. Indeed thinking about mental frames allows us to guess what is on the minds of both our students and the Harvard assistant professors. The reaction of both to saving reflects their current views regarding who they think  they should be."

  Apparently, the notion of saving for emergencies or major purchases is now also considered odd in an age of easy credit and welfare state safety nets. Yet making major purchases out of savings enables people to "earn" what the credit industry would earn from them.

  Opt-out automatic enrollment in 401(k) savings plans achieves substantially greater participation than opt-in plans. Most workers choose the "default" level of saving established by their employer. They apparently can't make their own decision.
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  Clearly, savings rates are not the result of rational optimizing decisions as assumed by standard economic theory. It is econometric work that requires this faulty assumption, because the psychological reality cannot be expressed by equations. Since the mathematical model cannot describe reality, reality must be bent to suit the model.

  "From the emerging theory of optimal control and dynamic programming, they developed the notion that individuals exactly balance the extra benefits from spending at different dates. This is now the fundamental paradigm of research, not only in macroeconomics but in many other branches of economics as well."

  The standard theory does accurately match broad life cycle saving patterns. There is after all some rationality in savings decisions. Savings tend to build up until retirement after which they are dissipated. as one would expect. However, without psychological factors, the standard theory provides no explanation for the extreme variability observed.
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  Indeed, the theoretical assumptions of optimal rational savings rates in effect assumes away the problems of savings, the authors perceptively point out. Most people save too little and leave themselves vulnerable during their increasingly lengthening retirement periods. Even with Social Security and pensions, many people fall short of financial security in old age. Eighty percent of American retirees depend on Social Security for more than half their retirement income.
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  The importance of savings is highlighted first by little Singapore and now in huge China - both of which have adopted a "high saving economy" model for economic development. The authors provide some interesting detail about efforts in China to encourage and even require substantial savings rates. They emphasize that the Chinese people have accepted the national "story" developed in Chinese propaganda that justified the sacrifice required for high savings rates. (The collapse of "iron rice bowl" benefits and low yields on available safe investment vehicles increase the need for large personal savings.)

  Without widespread access to credit, people have to save not just for retirement but for the proverbial rainy day and for major purchases as well.

  However, experiments - even with MBA students - generally show that people spend more when they can pay with a credit card than when they must pay in cash. Social cues - including keeping up with the Joneses - are part of the picture. The psychological elements are always important.

  "Animal sprits explain the puzzle of the arbitrariness and variability of saving. And understanding these animal spirits is in turn critical to the design of national policies on saving."

  Living in an age of chronic inflation also plays a major role in savings decisions. It increases the propensity to consume now before prices rise, and decreases the propensity to save now - something the authors don't deign to consider.

Financial markets:

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  The wide fluctuations in the financial markets clearly reveal the work of animal spirits. These wide, sometimes wild, fluctuations clearly don't conform to standard "efficient market theory."

  "No one has ever made rational sense of the wild gyrations in financial prices, such as stock prices. These fluctuations are as old as the financial markets themselves."

Leverage amplifies these cycles both on the upside and the downside. Somehow, regulators in Europe and the U.S. completely missed this important and common phenomenon during the boom leading up to the Credit Crunch bust.

  Wild fluctuations often can't be explained rationally even after they have occurred. Such factors as interest rate changes and subsequent dividends and earnings certainly influence stock market swings, but fall far short of explaining them. The swings are much too extreme to be based on predictions "based on economic fundamentals about future earnings."
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  Conceding that they cannot prove the negative, the authors stress the absence of proof supporting efficient market theory. A variety of well known feedback mechanisms that accentuate market cycles are summarized by the authors. Some are clearly psychological in nature. There are also feedback mechanisms by which markets impact the real economy, making substantial market swings a matter of importance for public and private decision makers. There is the "wealth effect on consumption," the impact on business investment plans, and corresponding swings in access to credit. There are "price-to-earnings-to-price" feed backs. There is also an obvious impact on the complex of psychological factors included in "public confidence."
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  Leverage amplifies these cycles both on the upside and the downside. Somehow, regulators in Europe and the U.S. completely missed this important and common phenomenon during the boom leading up to the Credit Crunch bust.
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  The authors stress psychological feedback mechanisms involving the senses of confidence and fairness. They point out the psychological differences that have influenced economic fortunes in Japan and Argentina, and note that these characteristics may change in the future.

  "Most economists don't like these stories of psychological feedback. They consider them offensive to their core concept of human rationality. And they are dismissive for another reason: there are no standard ways to quantify the psychology of people."

  This is precisely what FUTURECASTS has been explaining for over a decade, and what the publisher of FUTURECASTS has been explaining for over four decades.

  "Most economists view the attempts that have been made thus far to quantify the feedbacks and incorporate them into macro models as too arbitrary, and thus they remain unconvinced."

Risk and uncertainty:

 Decision making on the basis of incomplete information is a prominent characteristic of leadership in business as in war and poker. Decision makers parse the figures available but ultimately trust their gut and follow their dreams.
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The temptations of the credit markets will always break the resistance of the ethically challenged. Blind faith in markets is dangerous for individuals and economic systems and everything in between. A robust appreciation of risk is vital for the functioning of the risk/reward ratio.

  Businessmen are dealing more with "uncertainty" than with quantifiable "risk," the authors convincingly stress. They follow their "animal spirits" more than economic fundamentals. Feedback from financial markets seem to play a major role - boosting confidence on the way up and undermining it on the way down.
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  In the aggregate, investment does tend to follow economic fundamentals since investments that are out of line will fail or struggle while those that are supported by fundamentals are more likely to thrive. However, here, too, the economic fundamentals comprise only a part of the investment story.
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  The excessive boom and bust cycles in the financial markets demonstrate the need for supervision and regulation. The temptations of the credit markets will always break the resistance of the ethically challenged. Blind faith in markets is dangerous for individuals and economic systems and everything in between. A robust appreciation of risk is vital for the functioning of the risk/reward ratio.
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Aggressive participants create new entities outside the regulated sphere. Regulation, the authors assert, must constantly run faster to catch up with the increasing sophistication and complexity of the financial world.

  However, the proper policy response is to give reassurance to participants against various risks, the authors assert. Regulators should establish safeguards against sharp practices and certain risks, especially in finance and banking. This is what the SEC and FDIC and similar regulators provide. The authors praise such safeguards.

  However, such safeguards create moral hazard. They emasculate admittedly imperfect but nevertheless essential market disciplinary functions and the regulators repeatedly and inevitably fail to adequately fulfill that role.

  Aggressive participants create new entities outside the regulated sphere. Regulation, the authors assert, must constantly run faster to catch up with the increasing sophistication and complexity of the financial world. (Regulation will always run behind the power curve of financial change.)
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The real estate bubble:

  The psychological factors behind the current real estate bubble provide a prime example supporting the authors' thesis. Without rhyme or reason, people had "acquired a strong intuitive feeling that prices everywhere can only go up," the authors assert.
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Without rhyme or reason, people had "acquired a strong intuitive feeling that prices everywhere can only go up,"

  People uncritically accepted a standard real estate boom story about population growth, economic growth and the fact that "god makes no more land." (However, there is no limit to the capital that can be invested in the land.)  The authors also refer to "money illusion." People believe their home prices have risen perhaps 2000% from WW-II, but they have only doubled in real terms because of a tenfold increase in price inflation. This is an annual return of only 1.5%, well below the rate of return on many other investments.

  The authors miss the point. Chronic inflation is government policy - supported by Keynesian economists like the authors. A home is the best way for ordinary people to protect a big chunk of wealth from being eaten away even by low levels of inflation over time. That the purchase provides a profit. especially if the purchase is leveraged with a substantial mortgage as is the usual case, provides a solid basis for the view that, for most people, a home is a vital investment. Of course, a home offers shelter and so much more, in addition to investment profit. And, the profits are tax advantaged.

  There "is no rational reason to expect real estate to be a generally good investment," the authors ridiculously conclude.

  Government policy of chronic inflation, increasing ham-handed government efforts to allocate credit into housing, significant tax shelter offered for mortgage interest and home appreciation, the impact of explicit and implicit government guarantees that create moral hazard, artificially low interest rates extended over several years: here in such government policies one can find very good reasons indeed for credit bubble mania and the housing boom..
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  The government learns nothing. While Fannie Mae and Freddie Mac have been propped up at the expense of many tens of billions of dollars and put on a shorter leash, Ginnie Mae is now in the process of purchasing over a trillion dollars in subprime mortgages and the range of mortgages that qualify for FHA guarantees has been substantially extended. Why not? It's only taxpayer money, and taxpayers are a joke in Washington - and among Keynesians.

  Certainly, psychological factors were at work. The feedback from rising prices induced more purchases and more rising prices and confidence that bordered on mania. The authors are certainly correct that the housing bubble involved "all of the elements of our theory of animal spirits -- with confidence, fairness, corruption, money illusion, and storytelling."

  However, this is not just a tale of market failure. It is not just a tale of fraud and irrationality in the markets. Like the Great Depression and every recession since, it is yet another example as to how government constraints on market disciplines and other government policies prevent markets from functioning properly - examples Keynesians remain loath to acknowledge.\

Disadvantaged minorities:

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  The dysfunction of the African American underclass is a widespread problem that cannot be accurately understood as merely an economic problem. The lack of resources and skills and residual discrimination are just part of the story. Psychological factors including perceptions of unfairness and the stories people live by have particular relevance. Animal spirits are important factors.
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  In particular, the story of discrimination and mistreatment is qualitatively far worse for African Americans - and for Native Americans, too - than for other minority groups that have a history of struggle and success. It wraps African Americans in a trap that is psychological as well as economic, that keeps them apart, that prevents assimilation into the broader society.
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  Affirmative action and high quality education adapted to the special problems of underclass minorities are vital to deal properly with these problems, the authors assert. Rehabilitation programs should be widely available for those in prison who are willing to put out the effort to change their lives. Ordinary market opportunities are not enough. It is important to at least demonstrate concern and to commit resources to the effort to bring underclass minorities into the broader society.

  Unfortunately, the interests of the teachers unions are far more important than the interests of their African American and other poor minority students.

Conclusion:

  The authors sum up their criticism of conventional business cycle theory.

  "Conventional economic theories exclude the changing thought patterns and modes of doing business that bring on a crisis. They even exclude the loss of trust and confidence. They exclude the sense of fairness that inhibits  the wage and price flexibility that could possibly stabilize an economy. They exclude the role of corruption and the sale of bad products in booms, and the role of their revelation when the bubbles burst. They also exclude the role of stories that interpret the economy. All of these exclusions from conventional explanations of how the economy behaves were responsible for the suspension of disbelief that led up to the current crisis. They are also responsible for our current failure in knowing how to deal with the crisis now that it has come."

  Although they recognize regulatory missteps, the authors - as well as the standard theory - exclude most of the government policies that facilitate or undermine market disciplines. These are covered in Scott, "The Concept of Capitalism" Without that, the credit crunch - as well as the Great Depression and the economic contractions in between - are inexplicable, and the appropriate remedies impossible.

  However, concerning the current professional approach to economic theory, the authors hit the nail on the head.

  "In their attempts to clean up macroeconomics and make it more scientific, the standard macroeconomists have imposed research structure and discipline by focusing on how the economy would behave if people had only economic motives and if they were also fully rational." (emphasis in original)

  Especially with respect to the financial system, government must establish rules of the game, the authors point out. The deregulation of the 1980s clearly went too far. The temptations for excess and blatant fraud are too great, the swings of animal spirits too destructive to be ignored. Unfortunately, regulation was not only repressed, it failed to keep up with the changes in complexity and sophistication in the financial markets. This failure clearly played a major role in the credit crunch boom and bust cycle.

  The authors are clearly correct. The financial system is a part of the monetary system, and governments are unavoidably responsible for the monetary system. However, there should be no illusion, here, about the limits of regulatory effectiveness even at best. The regulators will always be one step behind developments. It will always be the markets, especially through business cycle contractions, that will cleanse the system - that will collapse the houses of cards and expose the fraudulent schemes before they can do even more damage.
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  Extensive efforts are currently underway to understand and develop serious changes in financial regulation. This will not be easy and will never be finished much less perfect. Regulation always faces a moving target. Continuous effort is essential.

  Much more dubious is the authors' standard Keynesian assertion that governments must step in to prevent the unemployment of business cycle contractions. The sense of fairness will always hinder wage reductions and make labor markets too rigid to quickly clear. The swings of the business cycle can be massively destructive. Creative destruction during cyclical contractions hurts the innocent as well as the culpable. The government must step in to mitigate these cyclical contractions, the authors urge.

  The massive monetary inflation and budget deficits are at least $10 trillion short of making up for the contraction of purchasing power in the financial system. The authors - and many other Keynesians - remain heroically undaunted by such large numbers. After all, it's just taxpayer money.