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The Failure of the Economy & the Economists

Barack Obama; drawing by John Springs

Why has there been so little discussion of fundamental issues like this distinction among losses? Why is so little said about the trade-off between the goal of allocating the economy’s capital efficiently and the need to shrink the enormous costs of the financial industry in doing so? One obvious reason is political. There is a long arc from Roosevelt’s acceptance of a useful role for government institutions and government regulation to the conviction of Reagan and Thatcher that the government is never the solution but actually the problem. A second, closely related reason is ideological: the faith, personified by Alan Greenspan with his early dedication to the writings of Ayn Rand and his staunch opposition to regulations while chairman of the Federal Reserve, that private, profit-driven economic activity is self-regulating and, when necessary, self-correcting.

The economists George Akerlof and Robert Shiller suggest a third reason. In their view, the problem is also intellectual—a systematic failure of thinking on the part of their fellow economists. Taking the title of their new book from a phrase famously used by John Maynard Keynes, Akerlof and Shiller argue that what is missing in the worldview of today’s economists is sufficient attention to “animal spirits,” by which they mean the psychological and even irrational elements that figure importantly in so many other familiar aspects of personal choices and personal behavior, and that, they believe, pervade economic behavior too.

Akerlof and Shiller identify five distinct elements in what they call “animal spirits”: confidence, or the lack of it; concern for fairness, that is, for how people think they and others should behave—for example, that a hardware store shouldn’t raise the price of snow shovels after a blizzard despite the increased demand; corruption and other tendencies toward antisocial behavior; “money illusion,” meaning susceptibility to being misled by purely nominal price movements that, because of inflation or deflation, do not correspond to real values; and reliance on “stories”—for example, inspirational accounts of how the Internet led to a “new era” of productivity. The omission of these five aspects of “animal spirits,” they argue, blocks conventional economics from either understanding today’s crisis or providing useful ideas for dealing with it.

Most of Animal Spirits consists of surveys of disparate research programs in which either Akerlof or Shiller or both have participated—in many cases, led the way—demonstrating that the conventional economic models fail to fit the facts of one or another aspect of observable economic behavior. The topics they cover include (among others) joblessness, saving, the volatile prices of financial assets and of real estate, and the prevalence of poverty among African-Americans. Akerlof, a professor at Berkeley who deservedly won the Nobel Prize in 2001, and Shiller, a Yale professor who in time should do likewise, are both outstanding economists, and the work they review in each of these areas of research is of high quality. In this respect, their book is similar to recent offerings by other scholars that have also presented for a broader audience many of the findings of what has come to be known as “behavioral economics.”3

Akerlof and Shiller, however, want Animal Spirits to do more than summarize distinct findings and their separate implications for policy. They see the limitations of today’s conventional macroeconomics as systemic: “the theories economists typically put forth about how the economy works are too simplistic. That means we should fire the weather forecaster.” And “firing the forecaster means giving up the myth that capitalism is purely good.”

In an intuitively appealing illustration, Akerlof and Shiller suggest how to think about what’s included and what’s not in conventional economic theory, and what they intend their book to accomplish:

Picture a square divided into four boxes, denoting motives that are economic or noneconomic and responses that are rational or irrational. The current model fills only the upper left-hand box; it answers the question: How does the economy behave if people only have economic motives, and if they respond to them rationally? But that leads immediately to three more questions, corresponding to the three blank boxes…. We believe that the answers to the most important questions regarding how the macroeconomy behaves and what we ought to do when it misbehaves lie largely (though not exclusively) within those three blank boxes.

One of the inevitable difficulties with this kind of argument is that it depends so much on just how words are used. What is the difference between an economic and a noneconomic motive? If I buy a new car because I like its styling and good gas mileage, that’s presumably an economic motive. What if it’s a hybrid and part of my reason for buying it is that I value the “story” of my doing my bit to help slow global warming? If a business owner provides scholarships for his employees’ children, is his motive to treat them fairly for fairness’ sake or to foster their loyalty and thereby improve their productivity?

The answer, in the end, is that an “economic” motive is whatever economists include in their theories of how people behave. And since different economists are always proposing different theories, what constitutes an “economic” motive can differ from one theory, and one economist, to another. Since at any particular time there are dominant theories, there is some coherence to what people would understand as an “economic” motive; and so the point Akerlof and Shiller are trying to make here is far from empty. But it is more elusive than they suggest. The distinction between what’s “rational” and what’s not is, if anything, even more fraught.

Sometimes, moreover, Akerlof and Shiller’s substantive arguments fall victim to a similar circularity. The element of animal spirits on which they place the most emphasis in their account of the current crisis is confidence. It is, they say, “the first and most crucial of our animal spirits.” Is it rational or not for me to put my money in a bank in which I have confidence? Or to buy a stock if I have confidence in the company’s business prospects? According to Akerlof and Shiller, this kind of behavior is, by definition, irrational since “confidence” for them is a kind of faith, not a matter of rational analysis: “The very term confidence…impl[ies] behavior that goes beyond a rational approach to decision making.” (Similarly, when confidence is explained in terms of trust, “the very meaning of trust is that we go beyond the rational.”)

This tendency to argue by definition also sometimes affects questions beyond whether something is to be classified as economic or noneconomic, or rational or irrational. One of the reasons confidence is so important in Akerlof and Shiller’s list of animal spirits is that when people have too much of it, they behave in ways that cause the economy to become overheated. But this argument, too, turns out to be a matter of definition: “The term overheated economy, as we shall use it, refers to a situation in which confidence has gone beyond normal bounds….”

Concerns like these aside, the broader question is whether Akerlof and Shiller succeed in making more of the different kinds of research they report on in Animal Spirits than the sum of the book’s disparate parts. The answer is yes in some respects, no in others.

They succeed in demonstrating both the narrowness of mainstream macroeconomic thinking in recent decades and the stranglehold that this thinking has placed on the economics profession’s ability either to explain phenomena like today’s crisis or to advance potential solutions. For example, economics today is largely taught using mathematical models to describe outcomes under different conditions. And for purposes of macroeconomics—the study of the economy as a whole—most of the standard models do not admit the possibility of unemployment. The reason is not that no one knows unemployment exists. Rather, no one has figured out how to allow for it within the confines of sufficiently simple mathematics; and faced with the choice between excluding unemployment and sacrificing analytical simplicity, most macroeconomists have opted for the former.

To point to another example even more central to what is happening currently, the standard macroeconomic analysis today also does not acknowledge the existence of banking or other kinds of borrowing and lending. Instructive models of credit markets are certainly available.4 But incorporating them within the standard macroeconomic models would place too much strain on mathematical simplicity.

Akerlof and Shiller succeed, too, in demonstrating that conventional macroeconomic analyses often fail because they omit not just readily observable facts like unemployment and institutions such as credit markets but also harder-to-document behavioral patterns that fall within the authors’ notion of “animal spirits.” Confidence plainly matters, and so does the absence of it. When the public mood swings from exuberance to anxiety, or even fear, the effect on asset prices as well as on economic activity outside the financial sector can be large.

As they argue, these effects can plausibly be larger than the fluctuations attributable to more concrete factors, such as monetary policy or oil prices, that economists more typically incorporate in their analysis. Money illusion, by which people are influenced by purely nominal price movements, is also clearly important to some aspects of how the economy in aggregate behaves. (As they show, concerns for fairness, tendencies toward corruption, and reliance on “stories” also influence some aspects of economic behavior, but whether they are significant for the aggregate economy remains unclear.) “It is necessary,” they argue,

to incorporate animal spirits into macroeconomic theory in order to know how the economy really works. In this respect the macroeconomics of the past thirty years has gone in the wrong direction.

The effort to “clean up macroeconomics and make it more scientific,” to impose “research structure and discipline,” has proved disastrously confining.

But what then? Is there more to Animal Spirits than a list of important influences for economists to try to take into account? Akerlof and Shiller believe they have proposed a new model for macroeconomic analysis. Comparing their work to Keynes’s discussion of animal spirits from the 1930s, they write:

This book…describes how the economy really works…. With the advantage of over seventy years of research in the social sciences, we can develop the role of animal spirits in macroeconomics in a way that the early Keynesians could not. And because we acknowledge the importance of animal spirits, and accord them a central place in our theory rather than sweep them under the rug, this theory is not vulnerable to attack.

There are two problems here. One is simply the familiar tendency to overstate, especially when writing about one’s own work. It is hard to believe that Akerlof and Shiller really see their ideas as invulnerable to attack. Similarly, after listing at the outset the subjects about which they will summarize the research that they and other scholars have done—e.g., “Why do economies fall into depression?”—they declare that “animal spirits provide an easy answer to each of these questions.” The answers they summarize may be right or not (I vote yes) and they may be well argued or not, but they are not “easy.”

The more important question is whether what Akerlof and Shiller have offered in Animal Spirits amounts to “a theory” in the sense that it could stand in place of the current theories that they criticize for being based entirely on rational responses to economic motives. There is a difference between a series of ideas about different aspects of economic behavior and an integrated account of macroeconomic fluctuations. Akerlof and Shiller are surely on the right track in pointing to elements that are missing from today’s conventional models, and in arguing that incorporating them into mainstream macroeconomic analysis would help. But they have neither done this nor shown others how to. Hence their goal of replacing what macroeconomists teach their students is likely to be disappointed, at least for now.

And because what they have here is a set of examples of how “animal spirits” matter for specific aspects of economic behavior, not a coherently worked out theory of how the macroeconomy behaves, it is not surprising that Animal Spirits is also thin on suggestions for what to do about the current crisis. Akerlof and Shiller mostly restrict their recommendations to how economists should think, not what policymakers should do. The one concrete proposal they offer is that the government should have a target for the expansion of credit—that is, for the amount of borrowing and lending in the economy, presumably defined in some measurable way.

This idea has considerable merit (some years ago I wrote a series of papers advocating it myself5). But it is hard to see how it would help address the problems our economy faces today. Everyone knows that a principal objective of the Treasury’s bank bailouts, the Federal Reserve’s numerous new facilities for credit, the government’s takeover of Fannie Mae and Freddie Mac, as well as other actions, is to restore the functioning of the credit markets so that borrowers can again obtain financing. It is not clear how stating a specific target for credit expansion would help further that goal. It is also not clear that the proposal follows, in any direct way, from the importance of animal spirits in influencing economic behavior.

What else? The “world of animal spirits gives the government an opportunity to step in,” Akerlof and Shiller write. But in what ways? Apart from a target for credit growth, they mostly leave it at that. “This book cannot give the detailed answers” to current policy questions, they write. This is a pity. Because they are so convincing in their critique of modern macroeconomics, and because they point to the current crisis as a prime example of why this matters, readers will understandably want to know what policies they would recommend.

In his recent book The Subprime Solution, Shiller offered a series of proposals, recommending, for example, a new version of the Home Owners’ Loan Corporation. which operated from 1933 to 1936 and provided generous subsidies for home mortgages, insisting, however, that they be paid off by steady monthly payments. He also advocated expanded financial disclosure requirements, greater availability of financial data, and a new government agency like the Consumer Product Safety Commission that could protect consumers by informing them about the safety of financial products.

Shiller made more far-reaching suggestions as well, proposing markets in which families could insure the risk inherent in owning their house6 or earning their livelihood, and even a new way of expressing prices in a unit of account that would adjust for inflation or deflation, so as to help people overcome money illusion. Here he anticipated the discussion of “animal spirits” in his book with Akerlof:

The subprime crisis was essentially psychological in origin…. Denying the importance of psychology and other social sciences for financial theory would be analogous to physicists denying the importance of friction in the application of Newtonian mechanics.

But The Subprime Solution was (by intent) mostly focused on mortgages and the fallout from the subprime collapse. In Animal Spirits, Akerlof and Shiller make a much broader argument, but they say little about its concrete implications for macroeconomic policies: How much and what kind of fiscal stimulus is desirable now? What should be the role for monetary policy now that short-term interest rates are near zero? What changes should be made in financial regulation once the crisis is past?

Some of the proposals for regulatory reform now being put forward by others appear at least to connect to parts of Akerlof and Shiller’s discussion. For example, they call attention to the potential instability inherent in the “new shadow banking system”—that is, institutions such as investment banks and even the off-balance-sheet entities sponsored by the banks themselves that now carry out many of the lending functions of banks but are not regulated as such and whose obligations are not ordinarily insured. They observe, correctly, that “there can be a ‘run’ on these institutions just as there can be a run on traditional banks.” They are right; what happened last year to Bear Stearns and Lehman was, in effect, a run on a nonbank.

But what, then, should be done to prevent more such runs? Some ideas now under discussion include stronger accounting rules and wider capital requirements, so that hedge funds and insurance companies and other nonbanks too would have to hold capital against their risk positions. There is also support for empowering the government to take “prompt corrective action” to force nonbanks to address problems in their balance sheets, or if necessary take them into receivership, just as it already can with banks. A more controversial idea is to reinstitute some form of the Glass-Steagall Act that, until Congress repealed it in 1999, barred commercial banks from also doing investment banking. The Obama administration has proposed a new financial “super-regulator.” How do animal spirits bear specifically on any of these issues? Akerlof and Shiller do not say.

But their silence on these and other policy issues and their lack of a full-blown “theory” to replace the strait-jacketed macroeconomics of the past few decades do not undercut the force of Akerlof and Shiller’s central argument. Their harsh judgment of current mainstream macroeconomic thinking is true, and they are right about the importance of what they call “animal spirits” to many of its crippling shortcomings. Animal Spirits provides an agenda for new thinking, and one well worth pursuing.

April 30, 2009


Betting on the Weather July 16, 2009

  1. 3

    See, for example, Richard H. Thaler and Cass R. Sunstein, Nudge: Improving Decisions About Health, Wealth and Happiness (Yale University Press, 2008), reviewed in these pages by John Cassidy, June 12, 2008.

  2. 4

    Interestingly, many of Federal Reserve Chairman Ben Bernanke’s most important contributions as an academic economist were models for analyzing the role of credit markets, including ways in which a falling value of either lenders’ capital or borrowers’ collateral can depress lending and therefore economic activity. See, for example, Bernanke and Alan S. Blinder, “Money, Credit and Aggregate Demand,” The American Economic Review, May 1988; and Bernanke and Mark Gertler, “Agency Costs, Net Worth and Business Fluctuations,” The American Economic Review, March 1989.

  3. 5

    See, for example, “Monetary Policy with a Credit Aggregate Target,” Journal of Monetary Economics, Spring 1983 Supplement.

  4. 6

    The market for futures based on either nationwide or city-specific house price indexes, which Shiller helped to establish on the Chicago Mercantile Exchange, is a practical step in that direction.

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