Tuesday, June 15, 2010

Akerlof and Shiller on "Animal Spirits" - A Brief Review

George A. Akerlof and Robert J. Schiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (Princeton University Press 2009).

I probably should have read this book when it was hot off the presses and everyone was still trying figure out the cause of the domestic and global economic downturn. In hindsight, a substantial part of the book's focus seems a bit obvious. The book remains valuable, however, for its decimation of the conventional economic wisdom, at least since Milton Friedman, that so-called "money illusion" is never a problem on the rational actor model. According to Friedman's view, there is no trade-off between price changes and the rate of unemployment. Individuals bargaining for wages are presumed to account for expected inflation in making wage demands. This view became a critical assumption of macroeconomic theories that led to deregulation of the financial markets, which preceded the real estate bubble and financial collapse.

Nobel-laureate George Akerlof and Yale economist Robert Schiller convincingly argue that money illusion exists because the rationality assumption of mainstream economics is faulty; human psychology and flaws in human psychology play important role in daily economic decision-making. Akerlof and Schiller refer to those flaws in human psychology, quoting John Maynard Keynes, as "animal spirits," which often prevent individual market participants, including those in wage markets, from accounting for expected future inflation or changes in prices. As a consequence, they confront "money illusion." The implication for Akerlof and Schiller is that government regulation of financial and other markets is necessary to prevent bubbles from arising as a consequence of money illusion. Markets require "the steady hand of government" to control the "animal spirits" that lead market participants astray.

While I agree with their conclusion, I must say that I am not convinced by Akerlof and Schiller's arguments for a couple of reasons. First, while they make a convincing enough case for market failure, they ignore the likelihood of government failure. Indeed, in the context of financial market regulation, there is evidence that government policies compounded the problem of animal spirits by promoting easy lending. Because government fails too, there is no reason ex ante to prefer regulated markets to deregulated markets. What is required is what Ronald Coase called a comparative institutional analysis of alternative institutional (regulatory and deregulatory) arrangements to determine which works best in the circumstances.

Second, in the last chapter, Akerlof and Schiller purport to have offered "a theory of animal spirits," according to which government intervention is necessary (and presumably sufficient) to improve market efficiency, or at least to reduce the amplitude of market upswings and downswings. The problem is that I don't really find any such "theory" in the book. I find references to human psychology and animal spirits, and I find anecdotes about how individual market participants make decisions, but the book does not present any real alternative or even amendment to the rational actor model. They do not even reference Herbert Simon's work on bounded rationality or the larger behavioral economics literature, which itself suffers to some extent from the same problem: lots of data but not much of a theoretical framework with which to replace the standard rationality assumption of economics.

Despite those major problems, I still agree with Akerlof and Schiller's conclusion that well-regulated markets (well-regulated is an important presumption) are likely to function better over time, with fewer and less extreme downturns, than unregulated markets. I am, like them, a Keynesian. But as Richard Nixon is reputed to have said in the early 1970s, "we are all Keynsians now."

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