Tuesday, July 21, 2009

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

No comments:

Post a Comment