Animal spirits, irrationality and markets

The current crisis brings about a radical shift in economic thinking. There is a hot debate among economists about the reasons why they failed in predicting the crisis. In fact, there is no consensus on the analysis of the causes of the crisis nor on the ways to get out from it. Now, the dominant view among (orthodox) economists is that we are seeing the light from the tunnel.

Economists who believe in the rationality of markets would be more incline to think that the crisis is just a temporary imbalance which has led the economy far from the equilibrium. John Maynard Keynes warned against this simplistic view: “Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” But all this is not about rationality, it is related to human psychology of economic behaviour.

In their book*, G. Akerlof, who shared the Nobel prize in 2001 for his work on information assymetries and R. Schiller - who predicted the dotcom and real estate bubbles - reassert the necessity of an active government role in economic policymaking by recovering the idea of animal spirits, a term John Maynard Keynes used to describe the gloom and desperation that led to the Great Depression and the changing psychology that accompanied recovery. Keynes's forgotten lesson is not here the theory of government spending; he asserts that the behaviour of economic agents is not inspired by a pure rational model, but is largely driven by irrational and psychological factors. Markets are not regulated by rational and imprescriptible laws; they are largely influenced by passions and interests of human beings. In other words, they can be guided by an economic policy geared to collective interest and full employment.

In past thirty years, this lesson has been forgotten. Likening the role of government to a parent's duty to create a happy home, the authors write: " The proper role of the parent is to set the limits so that the child does not overindulge her animal spirits . Likewise, they point out that 'no limits were set to the excesses of Wall street. It got wildly drunk...And now the world must face the consequences".

It is thus necessary to rethink the behaviour of economic agents whatever their motives are rational or irrational. Akerlof and Schiller examine some psychological factors which could influence economic behaviour - confidence or mistrust, bad faith, corruption, monetary illusion- and draw conclusions in terms of economic policy inspired by a 'good education'. In overlooking those factors and being confident in the 'invisible hand' of the market, (orthodox) economists made disastrous mistakes in their forecasts. They have developed sophisticated econometric models - for which some of them got the Nobel Prize- which turned out to be impractical.

The fundamental reason for which economists failed in their forecasts is because the market is largely influenced by a complex interaction of economic powers, instincts and passions. If asset prices go up, demand can also go up due to expectations on further increases leading to asset bubbles. As J.K. Galbraith wrote in his foreword to the 1993 edition of 'A Short History of Financial Euphoria', investors “might be reminded of the way not only fools but quite a lot of other people are recurrently separated from their money in a moment of speculative euphoria.” But, other 'innocent'people are separated from their money and their jobs.

In their analysis of the Great Depression, the two authors portray Keynes as a true 'liberal'- but he has inspired, nevertheless, the economic policy of many governments run by socialist parties, like the Jospin government in France. Right wing critics insist, conversely, that through balanced budgets and limited government regulation private markets would create jobs for any worker willing to get paid less than he produced. Keynes thought capitalism as productive system, but unstable and fragile, prey to the 'animal spirits' that lead to speculative mania and panic, which in turn leads to joblessness (quaintly described as 'involuntary unemployment').

In times of recession animal spirits tend to revive. The proper role of government is to temper these excesses through financial regulation- and to stimulate demand using deficit spending. In the wake of the crisis of the 30s, the Us governments showed excessive concern for balanced budgets but they still managed to impose some financial reforms and to stimulate demand. the authors point out, indeed, that fiscal policy was at that time insufficiently bold.

We have to think about the situation of the American economy in the 30s. There was a widespread feeling about the unfairness of the economy leading to labour unrest and the 'spectre of socialism (which the most conservative parts of the US society are still agitating today, for instance in the debate on healthcare reform). A key feature of animal spirits is 'money illusion': the inability to recognize that prices fell by 27 percent led Hoover, then Roosevelt to focus on raising real wages increasing purchasing power rather than stimulating demand to reduce unemployment.

As Keynes pointed out, the fundamental problem was that bankers were too reluctant to loan, because they thought they would lose their money. And some of the more 'radical' measures of the New Deal led capitalists to worry that market system would be replaced by a communist dictatorship, which further depressed their willingness to invest. Since deficit spending was not of enough scale to stimulate demand, economic pessimism tended to set in. Only with the emergency mobilization of World War II did the national economy begin to change.

Our contemporary economic problems cannot be directly compared with the situation of the 30s. However, Akerlof and Schiller end with a positive note: 'Yet we are currently not really in a crisis for capitalism. we must merely recognize that capitalism must live within certain rules". But we must take into account that irrational behaviour has a real effect on demand, necessitating government intervention.

Just a last observation on the general approach of the book. In their analysis, Akerlof and Schiller focus on individual agents, for which we can distinguish between rational and irrational motives. But our modern economies are also characterized by collective agents, firms, trade unions as well as the State. Choices made by these agents might be rational, but different from those of individual agents. The threat of being fired might lead workers to accept a reduction of their wages, but it could also determine a reaction from trade unions to defend the workers' wages, which in turn would cause cost increases for the firm and in macroeconomic terms a stimulation of demand.

From a different perspective, decisions taken on the basis of self interest might be contrary to the general interest if agents's behaviours are largely interdependent. We should rather make a distinction between public and private interests. Collective, rather than individual motives need to be evaluated every time in accordance with the general interest.


*George A. Akerlof and Robert J. Shiller, Animal spirits- How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism 230 pp. Princeton University Press. 2009

** J.K.Galbraith, A Short History of Financial Euphoria, - Foreword to 1993 Edition, Viking Press, 1994

The Minsky moment

The Economist (17 July) asks what went wrong and how the crisis is changing economic thinking. It writes: 'Economists need to reach out from their specialised silos: macroeconomists must understand finance, and finance professors need to think harder about the context within which markets work. And everybody needs to work harder on understanding asset bubbles and what happens when they burst. For in the end economists are social scientists, trying to understand the real world. And the financial crisis has changed that world'.

The current crisis has revived the debate among rival economic theories. Monetarism is dead and keynesianism is back. An economist, H.Minsky* has gained influence over a decade or so; although educated at Chicago , Minsky was nonetheless an enemy of the "Chicago School" of economists, who typically believe in the efficiency of markets. Building on Keynes' General Theory, Minsky argued that crises were integral to financial markets.

Minsky claimed that in prosperous times, when corporate cashflow rises beyond what is needed to pay off debt, a speculative bubble develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.

In other words, the longer economic stability lasts, the more risks borrowers will take. His model of the credit system shows that the cause of instability is the accumulation of debt. He distinguishes three types of borrowers (hedge borrowers, speculative borrowers and Ponzi borrowers). While some debtors are perfectly sound, others can only pay off their interest by renewing their loans. The third group of borrowers (that he calls Ponzi) sounds dangerously familiar: they borrow based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments.

The 'Minsky moment' - a term coined by an American economist, Paul McCulley** is the point in a credit or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden collapse in asset prices and a sharp drop in financial liquidity.

Minsky's financial instability hypothesis has received revived attention during the 2008 subprime crisis due to the debt accumulation problem. McCulley illustrated the three types of borrowing categories using an analogy from the mortgage market: a hedge borrower would have a traditional mortgage loan and is paying back both the principal and interest; the speculative borrower would have an interest-only loan, meaning they are paying back only the interest and must refinance later to pay back the principal; and the Ponzi borrower would have a negative amortization loan, meaning the payments do not cover the interest amount and the principal is actually increasing. Lenders only provided funds to Ponzi borrowers due to a belief that housing values would continue to increase.

McCulley writes that the forward progression through Minsky's borrowing stages was evident as the credit and housing bubbles built through approximately August 2007. Demand for housing was both a cause and effect of the rapidly-expanding shadow banking system, which helped fund the shift to more lending of the speculative and Ponzi types, through ever-riskier mortgage loans at higher levels of leverage. This helped drive the housing bubble, as the availability of credit encouraged higher housing prices. Since the bubble burst, we are seeing the progression in reverse, as businesses de-leverage, lending standards are raised and the share of borrowers in the three stages model shifts back towards the hedge borrower.

As Henry Kaufman, a Wall street economist and banker writes in the foreword of Minsky's book: 'now it is time to take seriously the insights of Hyman Minsky and build upon his groundbreaking work in order to find ways of putting our financial system on a more solid footing'. This sounds as a serious warning, but this means putting an end to the greed and cupidity of bankers. We badly need ethical rules and regulation to bring radical changes in the financial system.

* Hyman P. Minsky, Stabilizing an Unstable Economy, 2nd edition, Foreword by Henry Kaufman- McGraw Hill 2008

** Paul McCulley, The Shadow Banking System and Hyman Minsky's Economic Journey, PIMCO May 2009

G-8 in L'Aquila: success or failure?

The recent G-8 summit in L'Aquila, a small Italian town devastated by an earthquake, has raised many expectations. The agenda was ambitious, with three specific issues - climate change, aid to poor countries, mainly Africa and Iran- and a more general topic on the global economic crisis and the diagnosis on various policy responses.

On the economic crisis, diverging views exist between the US president - whose diagnosis is that the situation will get worse as the unemployment rate rose to 10% - and the other leaders (at the other extreme, the Italian PM considered that the worst is over and that the employment situation is not that dramatic!). In a recent interview (FT 1O July) , Larry Summers, former Treasury secretary and chief economist of the Obama administration said: “I don’t think the worst is over ... It’s very likely that more jobs will be lost. It would not be surprising if GDP has not yet reached its low. What does appear to be true is that the sense of panic in the markets and freefall in the economy has subsided and one does not have the sense of a situation as out of control as a few months ago.” If there is no consensus on the diagnosis and the causes of the crisis, it will be difficult to find common solutions.

Most newspapers and analysts have given ample information and commentary on the main outcomes of the G-8 meeting. On Iran, there was unanimity (including Russia) to condemn violence and repression as well as the negation of holocaust. On climate change, all countries accepted the principle of 2° C temperature increase as a limit, but emerging countries did not agree to cut their gas emissions. This will be a central topic for discussion at the Copenhagen summit, but the novelty is the US commitment to make significant cuts in gas emissions and to focus on renewable energy as a basis for their economic recovery programme.

On the aid issue, - perhaps the only succesful outcome of the meeting- world leaders pledged to commit $20bn over three years for a “food security initiative” to develop agriculture in poor countries, but aid agencies responded with scepticism, pointing to broken promises and switch in aid budgets. The G8 pledge at Gleneagles four years ago to give $50bn in development aid by 2010, with half going to Africa, has left a gap of at least $15bn so far. The summit statement addressed the scepticism, declaring: “Commitments to increase overseas development aid must be fulfilled. The tendency of decreasing ODA and national financing to agriculture must be reversed.”

Last but not least: the governance rules. The Italian Finance Minister has submitted, with the support of OECD experts and the German government, a 13 p document titled Global Legal Standards, which sets out a set of principles and ethical values- e.g. transparency, fight against corruption and tax fraud, fight against monopolies- on which, of course, there was unanimous consensus. But the rules still need to be defined and agreed by all countries before they can be enforced to banks and other financial institutions.

Since its inception by Giscard D'Estaing in the Rambouillet summit in 1975, the G-8 has been a forum of discussion and exchange of views on world affairs among the leading nations. It is not meant to take decisions as no country has transferred any part of sovereignty to it. After l'Aquila- which was in fact a G-14 summit- , it will be the G-20 in Pittsburgh to take over as a governance structure including China, India, Brazil and other emerging countries.

As Shakespeare's Portia says in The Merchant of Venice, ' If to do were as easy as to know what were good to do, chapels had been churches, and poor men's cottages princes' palaces'. It might be easier to set objectives, but more difficult to deliver them - in other words we need to establish the right institutions and start the processes that will achieve these objectives.

On Efficiency, Justice, Liberty

Keynes* wrote in 1926: 'the political problem of mankind is to combine three things: Economic Efficiency, Social Justice and Individual Liberty. The first needs criticism, precaution and technical knowledge; the second, an unselfish and enthousiastic spirit which loves the ordinary man; the third, tolerance, breadth, appreciation of the excellencies of variety and independence, which prefers to give unhindered opportunities to the exceptional and to the aspiring..."

Today we need to bring the institutions that foster this triad of efficiency, justice and liberty up to date.

Given the increase in productive capacity in the past fifty years, we can compromise on the goal of economic efficiency. We - in Europe- are rich. This means we can afford to sacrify some output to achieve social justice and individual liberty. This objective is well served by an economic order, involving State interventions that affect effectively the results of decentralized market processes. Huge centers of private power and inequalities in income compromise the goals of efficiency, justice and liberty. A policy that is willing to forgo the advantages of giant corporations and vast financial organisations seems highly desirable. In the light of recent experience, where the difficulties encountered by these large centers of economic power are central to the instability that affects the economy, they should, in the interest of efficiency and stability, be reduced to more manageable dimensions.

Social justice rests on individual dignity and independence from both private and political powers. Dignity and independence are best served by an economic order in which income is received either by right or through a fair remuneration. Dependance on expanding systems of transfer payments that have not been earned is alienating to the recipient and destructive of the social fabric. Social justice and individual liberty demand interventions to create an economy of opportunity in which everyone, except certain categories of the population, e.g. the handicapped, earns his or her life through the exchange of income for work. Full employment is a social as well as an economic goal.

It would be naive to think that all stated social and economic goals are mutually consistent. Emphasis on one objective may decrease the ability to achieve other goals, so priorities must be set. However, we should favour as an overriding goal personal freedom and democratic rights which serve the promotion of social justice.

In times of crisis, economic policy must reflect a vision inspired by the ideals of a good society. And it is evident that we are faced with a failure of vision, with a crisis in the aims and the objectives that economic policy should serve.

* Essays in persuasion" Norton& Company 1963. The essay was titled 'Liberalism and Labour' (1926)

A wisdom for a new age

Just before the G-8 meeting in L'Aquila, Pope Benedict XVI warned that there will not be any way out of the crisis without 'measures of ethical value', i.e. jobs and solidarity. In his encyclical 'Caritas in Veritate'*, he condemns the 'grave deviations and failures' of capitalism exposed by the financial crisis and advocates for a return to ethics in the management of the global economy.

The encyclical follows essentially the message of Paul VI's 'Popolorum progressio' (1967) which was largely influenced by the humanistic ideas of Father Lebret, J.Maritain and F.Perroux. Paul VI had an articulated vision of development. It could not be merely reduced to the increase in production of goods and services, but had a more fundamental meaning. The concept of development is broadly understood as the satisfaction of basic needs for people and indicates the goal of rescuing peoples, first and foremost from hunger and deprivation, endemic diseases and illiteracy.

The new encyclical brings the doctrine of 'integral human development' up to date . It calls, for a profound change in the foundations of capitalism, particularly in the relations between market, enterprise and State . It highlights the importance of distributive justice and social justice for the market economy: 'without internal forms of solidarity and mutual trust, the market cannot completely fulfil its proper economic function' (§35). It reaffirms the social responsibility of the corporate world: 'Today's international economic scene, marked by grave deviations and failures, requires a profoundly new way of understanding human enterprise...Without doubt, one of the greatest risks for business is that they are almost exclusively answerable to their investors, thereby limited in their social value' (§40). It places emphasis on the need for 'just laws' and 'forms of redistribution' of wealth as well as other forms of economic activity based on gratuitousness.

The 127 pages document is quite dense and addresses a range of many other important issues, including migration, terrorism, bioethics and energy.

The main 'political' message is, however, the call for a 'true world political authority' to 'manage the global economy, to revive the economies hit by the crisis, to avoid any deterioration of the present crisis and the greater imbalances that would result'. This idea is not likely to be endorsed by the Group of Eight summit nor to influence decisions on international governance at the next G-20 summit. But his plea for financiers to refocus on ethics will be reflected in the final declaration calling for stronger and more coordinated 'global standards'.

As Keynes put it emphatically, we need to 'invent a wisdom for a new age'. In this regard, the Church's document is an important step forward in the direction of a profoundly reformed system.

* http://www.vatican.va/holy_father/benedict_xvi/encyclicals/documents/hf_ben-xvi_enc_20090629_caritas-in-veritate_en.html