George A. Akerlof &Robert J. Shiller
FUTURECASTS online magazine
Vol. 11, No. 10, 10/1/09
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."
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.
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."
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.
The nature of economic
"confidence" and its impacts in economic systems is explained by
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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
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.
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
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.
The authors correctly point out that such adjustments fell considerably short of dispelling all money illusion impacts.
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.
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.
Business cycle history is inexplicable without reference to such
stories, and the tendency to forget them leaves us mystified as to the causes of
The role of psychological factors in two great
depressions - during the 1890s and 1930s - is emphasized by the authors.
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.
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.
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.
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."
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.
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.
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.)
A Keynesian cure:
The authors propose a Keynesian cure. They are,
after all, admirers of John M. Keynes.
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.
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.
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
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.
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.
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.
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.
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.
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.
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.
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.
The propensity to save is a psychological factor that clearly has important economic impacts.
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.
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.
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.
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.)
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.
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."
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."
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.
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.
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.
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.)
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
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.
There "is no rational reason to expect real estate to be a generally good investment," the authors ridiculously conclude.
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."
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.
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
The authors sum up their criticism of conventional business cycle theory.
However, concerning the current professional approach to economic theory, the authors hit the nail on the head.
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.
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.
Please return to our Homepage and e-mail your name and comments.
Copyright © 2009 Dan Blatt