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18 March 2010

Animal spirits – a richer understanding of economics

Filed under: books, Economics, irrationality, recession — David Wood @ 3:41 pm

It’s no secret that some of the fundamental assumptions of economic theory are faulty.

Specifically, the primary model in economics is that individuals invariably take actions which make good economic sense.  The mythical “Homo economicus” (“Economic Man”) is motivated at all times:

  • To purchase goods and services that have lower cost;
  • To create goods and services that they can sell at higher price;
  • To minimise the amount of effort that they have to expend to create these goods and services.

Real world people, of course, deviate from this model in numerous ways.  Lots of other things motivate us, beyond purely economic concerns.

Indeed, we can arrange human decisions on a two-by-two matrix:

  • On one dimension, decisions vary between economic motivations and non-economic movitations;
  • On the other dimension, decisions vary between rational and irrational.

Theories of classical economics take their lead from just one of the resulting four fields of life – the field of economic motivations that are pursued rationally.  But what impact do the other three fields have on overall economic questions, such as booms and busts, inflation, employment, savings, and inequality?

Many classicial economists give the strong impression that these other three fields have limited impact – somehow their effects average out, or can be discounted.  More recently, the rise of behavioural economics has challenged this conclusion, by increasingly providing evidence and analysis of factors such as:

  • Irrational biases in human decision making;
  • Herd mentality;
  • Limits of information;
  • The motivational importance of factors other than economic ones.

The best account I’ve encountered of this whole topic is the book “Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism“.

This book was authored last year by two eminent economists, George A. Akerlof and Robert J. Shiller.  Their phrase “Animal Spirits” is taken from Keynes – from a part of the thinking of Keynes that, they believe, has been too often neglected (even by people who describe themselves as followers of Keynes):

The markets are moved by animal spirits, and not by reason

(paraphrased from Keynes’ 1935 book “The General Theory of Employment Interest and Money”)

Akerlof and Shiller provide five chapters that explain each of five important contributors to “animal spirits”:

  • Confidence and Its Multipliers
  • Fairness
  • Corruption and Bad Faith
  • Money Illusion
  • Stories.

These explanations interweave many accounts of economic episodes over the decades, adding to the plausibility of the fact that these factors matter a great deal.

Next, Akerlof and Shiller show how considerations of these “animal spirits” provide deeper insight into each of eight key questions of economic theory:

  • Why Do Economies Fall into Depression?
  • Why Do Central Bankers Have Power over the Economy (Insofar as They Do)?
  • Why Are There People Who Cannot Find a Job?
  • Why Is There a Trade-off between Inflation and Unemployment in the Long Run?
  • Why Is Saving for the Future So Arbitrary?
  • Why Are Financial Prices and Corporate Investments So Volatile?
  • Why Do Real Estate Markets Go through Cycles?
  • Why Is There Special Poverty among Minorities?

To my mind, the analysis is devastating: any serious discussion of eonomics needs to take account of these findings.

Footnote: Amazon.com contains a whole series of nasty and devious reviews of this book.  Don’t be misled by them!  The motivations of the people writing these reviews would be a worthy subject for an analysis in its own right.  There are other kinds of “animal spirits” afoot here.

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6 Comments »

  1. Absolutely! “The markets are moved by animal spirits, and not by reason” are perhaps the most significant words ever penned by Keynes.

    It has echoes of the “invisible hand” of Adam Smith.

    Today, with much more information from the various sciences, we can (if we are prepared to make the effort to familiarise ourselves with these) begin to have a much better understanding of such matters.

    Economics, along with technology, the arts, and the like can now be seen to be evolutionary processes essentially akin to those off the genetic evolutiom of life.

    To quote a passage which I have recently posted elsewhere:

    “Our species likes to think we have control over such things as economics. We kid ourselves! Economic systems evolve autonomously. In the flowery words of Adam Smith “as if by an invisible hand”. Economic developments are tremendously complex and fraught with non-linearities, not least of which include the vagaries of human psychology. “The Death of Economics” by Paul Ormerod nicely underlines the essential futility of focussed forecasting.”

    We are little more than the vehicle through which the stochastically mediated forces of nature are implemented.

    More on this in latest edition of “Unusual Perspectives”, available in electronic format for free download from the eponymous website.

    Comment by Peter G Kinnon — 19 March 2010 @ 6:48 am

    • Peter – Thanks for your interesting comments.

      To clarify one point: I see one big difference between the “invisible hand” phrase of Adam Smith and the “animal spirits” phrase of John Keynes:

      *) “invisible hand” is the view that an overall optimum outcome is achieved, from the various actions of individuals (without these individuals seeking that overall outcome). So a rationally good outcome results from the actions of self-motivated individuals.

      *) “animal spirits” indicates that the overall outcome may be far from optimum – driven away from that optimum by, for example, the five factors analysed by Akerlof and Shiller.

      More: “invisible hand” fits with a belief in “inevitabilism” (one of my own current bugbears), whereas “animal spirits” matches my own view that the future of economics (and the future of human society) is very far from being pre-determined. Therefore, we individuals can make a real difference to the outcome.

      Comment by David Wood — 19 March 2010 @ 9:57 am

  2. There are many more examples of where these theories break down…

    Recruitment – banks are continually paying more for people because they base the judgement of who to employ on ‘relevant experience’, forgetting that relevant can be in similar fields and doesn’t have to be the bank down the road. Breaking into the ‘banking industry’ is virtually impossible, its a closed fortress. Banks aren’t the only ones. Taking someone with similar experience, adding a little, taking from them experience from other fields certainly makes more economic sense.

    Volunteering – many people volunteer, this is not economic, I coach rugby, it costs me travel, costs me in equipment, costs me in time, costs me in away matches, beer, food. I do it because I want to. Other people do all sorts of other volunteering, often at great cost to themselves.

    Business – many businesses never pay the originator as much as working for someone else would, occasionally you ‘get lucky’ (some say work hard, but ask the bosses of any failed business how hard they worked and it soon is apparent that hard work is not the answer). Given the chances of failure, the costs involved, the time and effort, I doubt a single new business would ever be started.

    All I can say is thank God these theories are such obvious bunkum.

    Comment by Dave — 19 March 2010 @ 12:09 pm

    • Hi Dave,

      If it really has been obvious for a long time that mainstream theories of economics are “bunkum”, these theories wouldn’t have been able to continue to hold such sway. Instead, I think the arguments are a bit more subtle

      For example, mainstream economists would presumably argue that:

      *) If some banks have short-sighted recruitment policies, it opens a competitive angle for another bank (perhaps in a different country), to recruit good people at lower cost, and (eventually) to displace their short-sighted competitors. Yes, perhaps a disruptive change may be necessary, but these do happen. In other words, irrational behaviour by some employers doesn’t mean the whole system fails

      *) The undeniable downside risks of starting your own business should be mitigated by a system such as exists in Silicon Valley, where people don’t lose their reputation just on account of business failures, and where there is sufficient venture and angel funding available to allow people to try, try, and try again (so long as their ideas look sufficiently credible each time).

      On the other hand, there is often “friction” that prevents these improved mechanisms from coming into place. The question of how to address that friction is where the debate gets more heated. Some say that the market will sort itself out, but the analysis in books such as Akerlof and Shiller (and also by John Cassidy) is persuasive, IMO, that external forces (ie governments and regulators) need to be brought to bear.

      Comment by David Wood — 19 March 2010 @ 12:59 pm

  3. ‘A Natural Economic Order’

    One interesting Economist who I believe will become popular in the near future is Silvio Gesell.
    “Gesell is the founder of the free economy, an economic outsider who was recognized by Keynes as his forerunner. Yet, he is seldom mentioned … maybe his passion for social justice was not popular.
    Gesell is still considered to be above all a Keynesian economist. he is an advocate of a school that believes in the lowest interest rate possible as a means of avoiding crises. Recognizing that reduction of interest rates doesn’t solve the problem alone, Gesell suggested the introduction of ‘free money’. His main work is a book with the title ‘A Natural Economic Order Through Free Land and Free Money’. (http://wikilivres.info/wiki/The_Natural_Economic_Order)

    For Gesell the real aspects of an economy is the claim on land and resources. This monetary aspect was recognized more clearly by Gesell than by Keynes. The current increase of interest on commodity trading today proves the shift into the real economy and not the derivative alchemies used by financial institutions today. Billionaire and philanthropist Warren Buffett described derivatives as financial weapons of mass distractions seven years ago. http://news.bbc.co.uk/1/hi/business/2817995.stm

    Comment by Marios Gerogiokas — 22 March 2010 @ 12:30 am

    • Hi Marios,

      Did you see the report on BBC News this morning about “Local Money”?

      It’s available online at http://news.bbc.co.uk/1/hi/uk/8579476.stm – “The town printing its own money”

      However, that system seems to lack some of the sophistication of what Gesell proposed

      Comment by David Wood — 22 March 2010 @ 9:19 pm


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