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.
What are animal spirits?
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.
In your book, you examine the causes of past depressions. Why do economies fall into depressions?
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.
We have to ask: as a Nobel Prize-winning economist, what do you think should be done about the financial crisis?
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.
You argue that humans’ propensity toward fairness can cause higher than expected rates of unemployment. Can you explain this?
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.
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?
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.
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?
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.