Animal Spirits: A Q&A With George Akerlof

It’s safe to say that macroeconomists haven’t been very popular lately. In fact, many people blame the profession for such sins as failing to predict the housing bubble and encouraging the deregulation of the financial industry.

In their new book Animal Spirits, the economists George Akerlof and Robert Shiller propose a new macroeconomic framework — one that incorporates real human behavior, with all its quirks and irrationalities. The book explores the intersection of economics and psychology and offers valuable insights into a variety of important economic policy issues.

George Akerlof, who teaches economics at the University of California, Berkeley, was awarded the 2001 Nobel Prize in Economics for his work on asymmetrical information markets. He has agreed to answer a few of our questions about the new book.

Question

What are animal spirits?

Answer

In The General Theory, written in the 1930′s at the heart of the Great Depression, John Maynard Keynes described the reasons that businessmen make investments largely psychological. He said that they could not really assign the probabilities to various outcomes, such as the success of a new ocean liner or a new coal mine, but instead they had to act on their intuitions, or their “animal spirits.” In our book Animal Spirits, Robert Shiller and I broaden Keynes’s concept to refer to psychological motivations more generally. We discuss five of these that are especially relevant to how the economy behaves. They are confidence, corruption and bad faith (or “snake oil”), fairness, money illusion, and stories. We show how these animal spirits lie at the heart of eight basic economic questions, which are as fundamental as why the economy fluctuates as much as it does, why monetary and fiscal policy affect output and employment, and why there is involuntary unemployment.

Question

In your book, you examine the causes of past depressions. Why do economies fall into depressions?

Answer

There can be many reasons why economies fall into depressions, but we think that the most major cause for depressions has been loss of confidence, usually associated with a financial collapse. They both feed into each other: the financial collapse feeds into the loss of confidence, and the loss of confidence feeds into the financial collapse; and both in turn also feed into reductions in output and employment.

These financial collapses are preceded by a period of overconfidence (of high animal spirits). In this period, investors and consumers are very trusting. They make incautious investments. In these times there are quick profits to be made from initiating financial investments for a quick profit and then passing them on to others. We call this the selling of snake oil. There are also stories regarding why this is a new era and there are special profits to be made. People and the press act on these stories and pass them on to one another.

Question

We have to ask: as a Nobel Prize-winning economist, what do you think should be done about the financial crisis?

Answer

We should have two targets: a target for aggregate demand and a target for credit. These targets force policy makers to have their eye on the ball. In the first target, there should be sufficiently large stimulus to aggregate demand that the economy would have at full employment. There should also be a credit target so that those who are doing legitimate business (not selling or buying snake oil) would be able to obtain loans under reasonable terms (on the terms they would normally obtain if the economy were at full employment and credit markets were operating normally).

For most important journeys, one of the most important decisions is the destination. By establishing and aiming for such targets (they are destinations for economic policy) the government will be able to plan sensibly. Roosevelt and Hoover had many programs. They were both very inventive about what to do in the Great Depression. But because they lacked firm targets, they were never sufficiently confident. The Depression could have been cured easily with an appropriately large dose of fiscal stimulus, but it was not applied. Unemployment in the United States only fell below 10 percent in 1941, which was some time after the start of the war in Europe, in September 1939. World War II, unfortunate as it was, then provided the fiscal stimulus that got us out of the Depression.

Question

You argue that humans’ propensity toward fairness can cause higher than expected rates of unemployment. Can you explain this?

Answer

Employers are reluctant to hire people at wages that employees consider to be unfair. What manager wants to deal with grumbling workers? But such wages may be higher than the wage at which employers would want to hire all those who are seeking jobs. The difference between those who want the jobs at these wages that employers pay and those who have jobs will be the unemployed.

Question

The current financial crisis has demonstrated the importance of national savings, yet people don’t seem to make rational decisions about personal savings. Can animal spirits shed some light on how people make savings decisions?

Answer

We economists are very proud of our theory of savings. It is called “the life cycle theory,” where people rationally save when they are young for their future consumption in retirement. There is a great deal of truth to this point theory, and it conforms to the facts. People in their middle years tend to save, and then older people dis-save in their retirement. But this theory does not explain why there is great variation in savings across countries. These differences, which vary from the almost zero saving rate of the U.S. to the almost 50 percent saving rates of Singapore, must be explained by differences in human psychology.

Question

The economics profession has faced a lot of criticism in recent months for its failure to predict the financial meltdown. Can an understanding of animal spirits help economists avoid such a mistake in the future?

Answer

We should be able to do much better in the future. We should have known that complex financial instruments that were potentially unbacked could lead to business failures and the break-up of financial markets.

But now we understand that with animal spirits, people will incautiously buy inadequately backed securities if they are overconfident. Insurance is regulated so that if your house burns down, the insurance company will have the money to pay. The same should be the case of other financial assets: they should be regulated so that people’s expectations will be met regarding whether or not they will be paid off. The mortgage market is only one financial market where people showed overconfidence. There was much greater need for regulation of financial markets.

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  1. Bobby G says:

    Keynes mentioned in the first sentence of his response, eh?

    I don’t mean to be a harsh critic but when I read their “animal” behaviors, “confidence, corruption and bad faith (or “snake oil”), fairness, money illusion, and stories,” I just think these are fancy ways of saying “risk assessment and incentive structures.” In the final answer, I would disagree that insurance companies are (or at least should be) *regulated* to pay… in fact that is their private market business structure. Why does the government necessarily have to get involved?

    I guess I just get put in a sour mood when I read things that imply “encouraging the deregulation of the financial industry” is a bad thing. Everyone who says that (and there are many), I believe, doesn’t understand what happened to our economy.

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  2. Brad Harbach says:

    “Where people rationally save when they are young for their future consumption in retirement”

    I’m fascinated with how backwards our conventional savings patterns are. Why is it that we choose to make sacrifices during our years of greatest health and ability to provide us with opportunity during our years that we are least able to fully take advantage of it?

    As a young American in my twenties I’m surrounded by others who choose the unfullfilling pattern of slaving five days a week at work to enable them to spend the weekends out at the bars and ultimately hope to save a few bucks each week to enable them to fulfill all of their lifelong dreams once they retire at 65. Why do we foolishly all believe this is the good life?

    As an example: Everyone dreams of traveling – “some day I want to go to “. Why can’t we learn to live life now instead of always procrastinating all of our lifelong dreams until retirement? I’ve written about overcoming your fear of LIVING NOW and I think it offers some good advice to help you get out of always living for the future.

    http://www.twentysomethingsense.com/2009/04/stop-dreaming-start-traveling.html

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  3. W says:

    Animal spirits? The answer to rebuilding macroeconomics is incorporating the irrational psychology of animals? I can appreciate the application of economist’s tools to psychology (freakonomics), but this would appear to be the application of dead psychologist’s tools to economics. I find it absolutely terrifying that economist’s appear now to be on the path of re-hashing early 20th century theory. Good luck with that…it worked so well the first time. Here’s a clue: Behaviorism was the spark that led them out of that hole towards something with some kind of practical value…

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  4. Leo says:

    >>I don’t mean to be a harsh critic but when I read their “animal” behaviors, “confidence, corruption and bad faith (or “snake oil”), fairness, money illusion, and stories,” I just think these are fancy ways of saying “risk assessment and incentive structures.”<<

    I have not read the book, but I think it’s trying to make precisely the opposite point: Risk assessment and incentive structures are fancy ways of saying fear and greed (animal spirits).

    My personal opinion is that this is probably correct. I do not know any completely rational human beings, so it is not obvious to me that economic models based on completely rational economic actors will accurately reflect reality. It’s kind of like building fluid dynamics theory by assuming only laminar flow – it might look like real life under a very limited set of conditions, but it’s going to miss some very interesting and important effects.

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  5. noah says:

    @Bobby G

    “In the final answer, I would disagree that insurance companies are (or at least should be) *regulated* to pay… in fact that is their private market business structure. Why does the government necessarily have to get involved?”

    Because if it’s not regulated, it isn’t really insurance. An unregulated insurance company will go bankrupt if they are hit with more claims than expected. If they can’t pay you when you make a claim, then you didn’t really get insurance, did you? If it’s not regulated, it ends up being fraud (more or less) and we end up where we are now.

    If credit default swaps were regulated like most insurance is, then when the mortgages went bad, there would’ve been sufficient funds to cover the losses and no crisis. They weren’t though, so it wasn’t really insurance. It was warm fuzzies and vague assurances to pay that weren’t really backed by anything.

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  6. ali b says:

    Brad Harbach is absolutely right. We all need a good life now.
    I notice that people from Germany and Sweden are able to travel and have some free time to improve themselves with study or hobbies. They have a safety net that will care for them in old age if necessary.

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  7. Bobby G says:

    @ Leo (#4),

    Reflexive property. The point was they are the same thing, and that there is no “novel” idea about calling these influential factors by different names. Not to mention words like “risk assessment” and “incentive structures” have existed long before “animal spirits.”

    I don’t like the excuse you give about rationality. Just because sometimes people are irrational doesn’t mean being rational is not better. It is always better, for you, to act in your own self interest… by definition! If (as economics dictates) acting in your own self interest can, in fact, benefit others (think mutually beneficial trade, one of the most basic economic concepts), and, on a larger scale, rationality can benefit an organized economy, shouldn’t we then promote rationality?

    Free market economics inherently punishes irrationality; those acting irrational will lose money (and thus economic power and influence) to those acting rationally. Thus there is a cost to acting irrationally and a benefit to being rational. I feel like this is a very healthy innate incentive structure that is only skewed by government intervention. While market failures do exist, permanent (seems like it is anyway) government intervention is never the absolute instant fix.

    I know in reality people are irrational. I do not think that gives us the excuse to reward irrationality, however. (Evidently, in this country, a lot of people do.)

    And P.S., Brad, being in my 20s as well I can appreciate your point, but good luck trying to start a life and/or a family at age 30 or 35 having been out of school without a career for 10 years and competing against the “fresh young minds” aka overachievers of the day. I wish the world operated like the way you say but it doesn’t, and pretending it does will put you at a very real disadvantage later, and may possibly affect the opportunities and benefits that you can only experience when you are older (think family and friends). That being said, the reasons you list are my validations to not worrying about my money too much today, but I do consider working to be very important for long term career development.

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  8. Bobby G says:

    @noah (#5),

    Apologies for the double post, but you’re wrong.

    “An unregulated insurance company will go bankrupt if they are hit with more claims than expected.”

    That is not regulation, that is insurance (yes, on an insurance company), and that is a different topic. And bankruptcy is not fraud as you imply. I think transparency would be the best solution… if you want insurance, there’s demand for insurance, and as a consumer you will shop around for both the best price and the best quality (i.e. the firms that handle money the best and are least likely to go bankrupt if you need to file a claim). I don’t see a real market failure here, and I don’t know why the government should need to *regulate* the industry, nor even why they need to financially back it. Let people who invest irrationally suffer, let those who make good decisions benefit.

    As for your second point, I think the real problem was over-valuation of those assets due to very poorly managed, already existing government regulation (federally-backed Fannie and Freddie who purchased pretty much any mortgage that applied… hey if you can reap all the profit and all the cost goes to the taxpayer, why wouldn’t you?). Just like with the insurance company explanation above, if people were allowed to value mortgages and securities in a pure free market (not one inflated by the government-backed firms with a seemingly unlimited demand, thus driving up prices and inflating profits for everyone), there would be no financial problem. Once again, people who made bad investments would suffer, and people who made rational investment decisions would profit. That’s the way it should be in my mind… I want to be rewarded for being smart, I don’t want to have to pay taxes to support the people who weren’t smart (yet who stood to make a ton of money anyway).

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