There's an old joke about a football player, a physicist, and an economist stranded on an island with a single can of beans and no way to open it. The football player offers to bash the can open with his forehead, but the physicist says that won't work and, besides, he doesn't like blood in his beans. The physicist offers to climb a coconut palm and sling down a coconut at a precise velocity and angle, but the football player says that won't work and, besides, he doesn't like coconut in his beans. Finally the economist smiles and says, "First, let's assume we have a can opener."
The joke works because economics is a science built on assumptions that don't always correlate to experience, and that is most obvious with the Rational Economic Actor. It is precisely this myth that Nobel Prize-winning economist George Akerlof and co-author Robert Shiller address in their new book, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.
More below the fold....
Animal Spirits, Part I - Irrational Economic Actors
This week, Morning Feature will explore Akerlof and Shiller's new book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Today we'll consider the five "animal spirits" - informal, intuitive modes of decision-making - that Akerlof and Shiller say are primary economic drivers. Thursday and Friday we'll look at the eight "big questions" they argue are central to understanding the macroeconomy. Saturday we'll conclude the series with a critique of their theory.
Economics has been described as a body of excuses to use when its assumptions fail. While it's not quite true, like the joke in today's introduction, it's based on a kernel of truth. Economics makes assumptions about how people make economic decisions, based less on observation of human decision-making than on how economists think such decisions should be made. We should be Rational Economic Actors who, for a given economic decision: (a) compile a list of options; (b) calculate a mathematical expectation for each option based on its potential gain if it succeeds, its potential loss if it fails, and its probabilities of success and failure; and, (c) choose the option with the best expectation, indexed to our risk tolerance. Economic theory assumes we do that every time, and with complete access to the relevant data.
In fact we rarely if ever make decisions that way, and even if we try to we're guessing about most of the data. Instead, we rely on what Akerlof and Shiller call "animal spirits," informal and intuitive decision-making processes. They argue that this massive gulf between economic theory and human behavior is the main cause of economic boom-and-bust cycles. They argue that if macroeconomic theory is to be usefully predictive, it must account for and include some mechanism for bridging the gulf between the mythical Rational Economic Actor and the actual behavior of human beings.
Note: The authors do not use "animal spirits" or "irrational" to mean we're mindless beasts. They mean simply that we use informal, intuitive decision-making more often than we use formal, quantitative analysis. The problem is less how we make decisions than that economics makes false assumptions about how we make decisions and economic policy is based on those false assumptions.
Akerlof and Shiller argue that market factors cannot bridge that gulf because the market is driven by our "animal spirits" rather than by quantitative analysis. Only government, practicing Keynesian policies, can counterbalance our "animal spirits" and preserve a stable economy.
The five animal spirits.
But in order to do that, Akerlof and Shiller argue, we must understand how we make intuitive decisions, and how our intuitions drive the economy. Their phrase "animal spirits" is taken from the Latin word anemos, meaning roughly "wind or breath of life," the impulses that move our intuition. They offer five animal spirits:
- Confidence - This implies not only a prediction about the future ("I'm confident things will get better") but also a measure of trust and belief in social structures and leaders ("I have confidence in him/that"). The Latin roots for confidence (fido, trust) and credit (credo, to believe) are very similar. The authors argue that coincidence is important: credit is a function of confidence; if we lose confidence in our economy, then credit will dry up. Because credit is the lifeblood of most activity, a drop in confidence can itself bring an economy shuddering to a halt.
- Fairness - While often minimized or defined into irrelevance by economists, Akerlof and Shiller argue that fairness is a fundamental element of human behavior. Most of us want to be fair, want to live in a society we judge to be fair, and want society to punish unfair behavior. But they offer an interesting insight, based on experimental data: status plays a key role in our fairness impulse. For example, we're more likely to seek advice from a peer than from an expert, as we think it's "unfair" to ask experts for their advice (unless we pay them). That status-based view of fairness skews our economic decisions; we judge the "fairness" of a price as much by the seller's status as by our need or desire for the product or service.
- Corruption and Bad Faith - This can be seen as the flip side of confidence and fairness. Akerlof and Shiller argue that all three of the most recent recessions - in 1990-91, in 2001, and today's crisis - were triggered in part by scandals (the S&L, Enron, and subprime mortgage scandals, respectively). When conditions are ripe for corruption, the authors argue, executives behave as predators rather than treating their businesses as providers of goods and services. In particular, they use deceptive accounting practices to hide self-dealing and other methods of looting corporate assets, keeping stock prices high while the debt-asset-profit value of the business is collapsing. They then skate away leaving their shareholders, consumers, and the taxpayers holding the bag. Both the financial shock of the collapse and the emotional shock - the loss of public confidence in our economic structures - create ripples of failure.
- Money Illusion - This is a technical term and it has to do with whether we evaluate wages, prices, and contracts in nominal (fixed) dollars or factor in the expected rate of inflation. Historically, economists assumed that few of us saw through the "veil of inflation," and thus we made decisions based on money illusion (nominal dollars). This led to the Phillips curve, developed by Australian economist A. W. Phillips in 1958 based on 97 years of data from the British economy, and suggesting an inverse ratio between unemployment and inflation. If more people are employed, demand and hence prices will rise. If fewer people are employed, demand and hence prices will fall. That theory changed, very abruptly, in late 1967 when Milton Friedman proposed that workers and consumers are rational - bargaining for inflation-adjusted wages and prices - and thus that money illusion does not exist. Within four years Friedman's theory became assumed fact throughout economics and remains so today. Akerlof and Shiller present evidence that while we may consider inflation in some contexts, there are other important arenas where we clearly do not (e.g.: most employment contracts do not include cost of living adjustments). The authors argue, later in the book, that money illusion requires different economic policies.
- Stories - This is the most important, because it affects our impressions of the other four. Akerlof and Shiller argue that we are a story-telling species, and we remember facts (or things we believe to be facts) not as isolated nuggets of knowledge, but in terms of stories. If a nugget fits into a story we believe, we believe the nugget to be true, and we'll repeat and spread that nugget by telling the story to others. Most conversations are exchanges of story-telling, and research suggests our relationships are based on shared stories as much as shared values or experiences. Economists usually don't treat stories about the economy as data, treating them as (usually weak) explanations of facts. Akerlof and Shiller argue that our stories don't explain the facts; they are the facts we act on. They argue that stories spread virally, by word of mouth, and their spread is based not on truth but plausibility. If the story "feels true," it spreads and is acted upon as if it were true, and the story itself becomes an economic driver.
Akerlof and Shiller argue that these "animal spirits" - psychological impulses - offer a better explanation of economic events. They test their theory with what they consider the eight "big questions," and tomorrow we'll examine the first four of those questions.
Happy Wednesday!