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Why do recessions and depressions happen?  Why are central banks so important?  Why can't everyone find a job?  Why will suppressing inflation increase unemployment?

These are four of the eight "big questions" that Nobel Prize-winning economist George Akerlof and co-author Robert Shiller explore in their new book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.  Their answers are intriguing.

More below the fold....

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Animal Spirits, Part II - Recession, Banking, Unemployment, Inflation

This week, Morning Feature explores Akerlof and Shiller's new book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.  Yesterday we considered their rebuttal of the myth of the Rational Economic Actor.  Today we examine their answers to four "big questions" of recessions, banking, unemployment, and inflation.  Tomorrow we'll look at their other four "big questions" of savings, investment volatility, real estate cycles, and minority poverty.  Saturday we'll conclude the series with a critique of their theory.
Both science and religion begin with the question "Why?" although they offer very different methods for answering that question.  Economics often seems like something of both, presenting its arguments in the mathematical language of science, but basing those arguments on unproven and unprovable assumptions that are little more than articles of faith.

Rather than predicting how humans will conduct transactions, economists too often describe how we would conduct transactions if we were Rational Economic Actors operating in an Efficient Market.  Both in examining past economic events and in offering solutions to contemporary challenges, economists often try to fit messy data into idealized forms that assume we all apply formal, quantitative analysis with complete knowledge of the relevant facts, rather than admitting that we use intuitive reasoning based on compelling or attractive stories.

The problem is not that we make horrible decisions, although sometimes we do.  The problem is that we don't behave in the ways economists assume we do.  Economic descriptions and prescriptions are based on theoretically convenient assumptions rather than actual human behavior, and that gulf creates policies that are - to imitate the language of the field - more than marginally failure-prone.

Translation: "Oops."

Four "big questions" and some different answers.

After introducing what they consider the five major impulses that drive our intuitive economic reasoning - confidence, fairness, corruption and bad faith, money illusion, and stories - Akerlof and Shiller consider a series of "big questions" in macroeconomics.  In each case they first lay out the prevailing economic theory based on assumptions of rationalism and efficient markets, then offer a different theory based on their five animal spirits.  Today we'll look at their first four questions:

1. Why do economies fall into depression?  While this includes recessions, the authors focus on depressions because they offer a better contrast.  They explore both the Great Depression and the earlier crisis in the 1890s, and conclude that both were grounded first in crises of confidence, fueled in part by stories of corruption and unfairness.  In the 1890s this led to a banking collapse; in the 1930s it led to a stock market collapse.  They argue that both depressions were deepened and prolonged by money illusion - reluctance to correct wage expectations for deflation and thus boost employment - and that the Great Depression was further prolonged by investors' skepticism that the U.S. would remain a profitable market economy.  Interestingly, they argue that both Herbert Hoover and Franklin Roosevelt tried to take correct steps to curb the Great Depression, but neither understood the problems well enough to act boldly enough, or to explain and defend their actions in terms that would restore confidence among workers (Hoover) and investors (Roosevelt).

2. Why do central bankers have power?  In this chapter, Akerlof and Shiller explore why the Fed was created, and how monetary and fiscal policies affect the economy.  Both their description of prevailing theory and their differing theory are very technical, and the "take away" is in their postscript to the chapter.  In the current crisis, they argue the government should have two simultaneous targets: (a) a sufficient fiscal stimulus to boost employment; and, (b) a sufficient, targeted financial program to restore credit as if there were already full employment.  The economy cannot grow without people working, but they argue that ordinary fiscal stimulus can't generate employment until and unless credit markets are restored with both confidence and legitimacy (transparency).

3. Why are there people who cannot find a job?  Here they look at involuntary unemployment - people who want jobs but can't find them - and they offer an intriguing insight.  The simplistic theory is that any unemployed person should be able to sell his labor if he's willing to accept a wage that employers are willing to pay.  But "efficient wage theory" suggests the floor on labor pricing is set by employers, as they want employees to be efficient and not quit over any trivial workplace dissatisfaction.  Employers must pay more than "market clearing wages" that would yield full employment, as an employee making only "market clearing wage" has no reason not to "sell his labor across the street" if dissatisfied.  Akerlof and Shiller argue this isn't quite true, as the employment transaction is also a human (employer-employee) relationship, and employees have other motivations to be efficient and stay with their jobs.  Thus, they suggest, the "efficient wage" floor is probably nearer (but not equal to) the "market clearing wage," and we could reduce unemployment (somewhat) by lowering the "efficient wage" floor.

4. Why is there a trade-off between inflation and unemployment?  Here the authors challenge Milton Friedman's "natural rate" theory that there is one sustainable level of unemployment that will yield neither inflation nor deflation.  Friedman's analysis suggests that so long as unemployment is at its "natural rate," monetary policy can keep inflation near zero without any employment consequences.  Akerlof and Shiller show that there is at least some money illusion - we ignore small margins of inflation in our economic decisions - and thus using monetary policy to keep inflation near zero will ultimately increase unemployment.  Worse, during a recession where unemployment is rising, they argue a monetary policy focused on price control (preventing inflation) will accelerate and prolong unemployment shocks.

Note: These are brief summaries of complex arguments, and I've omitted their supporting research.  For another, more detailed look at that research, FarWestGirl found an article titled "The Science of Economic Bubbles" in this month's Scientific American.
Tomorrow we'll look at Akerlof and Shiller's other four "big questions" - savings, investment volatility, real estate cycles, and minority poverty.

Happy Thursday!

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Originally posted to NCrissieB on Thu Jul 09, 2009 at 04:26 AM PDT.

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