Book Review – Animal Spirits: How Human Psychology Drives The Economy, And Why It Matters For Global Capitalism

Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism By George A. Akerlof and Robert J. Shiller Princeton, New Jersey: Princeton University Press, 2009. Pp. xiv, 230. $24.95 cloth. Economists today are justly concerned about the inability of neoclassical economics’ as if assumption of hyper-rationality to explain, no less to predict, the macroeconomic swings of recent years. They also are concerned that incremental policies based upon this assumption often worsen already bad situations. So, if the answers do not lie within economics, then where are they to be found? Two distinguished economists, George A. Akerlof (Berkeley) and Robert J. Shiller (Yale), believe the failures of economic theory result from economists’ failure to incorporate the peculiarities of human behavior into macroeconomic models. Accordingly, their book, Animal Spirits: How Human Psychology Drives the Economy, and Why it Maters for Global Capitalism, conflates theory and evidence from social science with that from economics. They argue that economists and policy makers must pay closer attention to human nature as it is, and not as the self-serving assumptions of neoclassical economics require it to be. The authors shun the sociobiological meaning of “animal spirits,” which explains human behavior in terms of survival and reproductive value. They adopt instead a stylized meaning, calling it “an economics term, referring to a restless and inconsistent element in the economy. It refers to our peculiar relationship with ambiguity or uncertainty. Sometimes we are paralyzed by it. Yet at other times it refreshes and energizes us, overcoming out fears and indecisions” (4). The authors describe five animal spirits judged relevant to macroeconomic performance; viz., confidence, fairness, corruption and bad faith, money illusion, and storytelling. The balance of their book tells stories about macroeconomic glitches caused by “irrational behavior and noneconomic motives” (168). (Economists traditionally explained such effects in terms of bounded rationality, rational ignorance, and non-pecuniary payoffs.) The authors interpret, along “animal spirit” lines, instances of economic depression, the power of central banks, unemployment, the Phillips Curve, savings rates, asset price volatility, real estate cycles, and minority poverty. They contend that their blend of economic and non-economic factors fits the available data, history, and stories. Conventional economic models, in their view, describe macroeconomic behavior only to the extent that individuals act rationally and have purely economic motives. It falters, by comparison, where behavior is less than fully rational, and where payoffs are not easily expressed in money terms. They conclude, therefore, that “[i]t is necessary to incorporate animal spirits into macroeconomic theory in order to know how the economy really works” (168). The book offers no detailed answers to the troublesome questions raised within. Accordingly, the authors’ conclusions are general and rather predictable. They aver that “if we thought that people were totally rational, we too would believe that government should play little role in the regulation of financial markets, and perhaps even in determining the level of aggregate demand” (173). However, “a world of animal spirits gives the government an opportunity to step in. Its role is to set the conditions in which our animal spirits can be harnessed creatively to serve

the greater good. Government must set the rules of the game. ... Without intervention by the government the economy will suffer massive swings in employment. And financial markets will, from time to time, fall into chaos” (173). The authors identify several issues that they contend cannot be resolved through economic reasoning alone, requiring instead a “detailed understanding of confidence, of fairness, or opportunities for [private] corruption, of money illusion, and of stories that are handed to us by history” (176). This book, in their view, provides “the background story within which all of these answers should be worked out. And it also stresses the urgency for setting up the committees and commissions to develop the reforms in financial institutions and the regulations that are so immediately needed” (176). The case for economic performance being more complex than is dreamt of in the philosophy of neoclassical economics is worth arguing, and the authors make interesting work of it. Their prescription, however, ignores what is perhaps the most challenging problem of all – that the individuals appointed to committees and commissions are vulnerable to the same animal spirits and instincts as the populace whose interests these individuals are called upon to represent. Competing explanations of macroeconomic behavior paint a darker and arguably more complete picture of human nature and macroeconomic performance. Public Choice reasoning, for example, suggests that policies intended to overcome animal spirits are liable to worsen macroeconomic performance. The authors’s story is consistent with this conclusion. Their discussion generally avoids the countervailing problem of political self-interest. Where necessity requires them to address it, however, their analysis is devastating. For example, they attribute the current financial crisis to a real estate bubble arising from irrational overconfidence (an animal spirit) plus widespread uncertainty as to the point at which the bubble would stop rising and ultimately burst. Surprisingly, they describe the crisis’ root cause without recourse to their “animal instincts” thesis; to wit: “Andrew Cuomo, Secretary of the Department of Housing and Urban Development, responded [to the claim that minorities deserved a greater opportunity to amass real estate wealth] by aggressively increasing the mandated lending by Fannie and Freddy to underserved communities. He wanted results. The possibility of a future decline in home prices was not his concern. He was a political appointee. His charge was to secure economic justice for minorities, not to opine on the future of home prices. And so Cuomo forced Fannie Mae and Freddie Mac to make loans, even if that meant lowering credit standards and relaxing the requirements for documentation from borrowers. There was never any serious examination of the premise that this policy was in the best interest of minorities.” (155) Neither was any serious consideration given to long-term macroeconomic performance. The reader might easily conclude that this fatal policy decision served only the political interest of Andrew Cuomo and the political party to which he belonged. The reader also might conclude that political spirits, rather than animal spirits per se, bear much if not most of the blame for the resulting financial chaos. This suggests a sixth irrational animal spirit affecting macroeconomic performance: the unwarranted belief in government’s ability to correct departures from textbook economic efficiency, whatever their cause. James A. Montanye