Economics and psychology

  • Business
  • Saturday, 12 Sep 2009

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (Hardcover) Author: George A. Akerlof and Robert J. Shiller

“CAPITALISM can give us the best of all possible worlds, but it does so only on a playing field where the government sets the rules and acts as a referee.”

Classical mainstream economic theory suggests that when we make significant investments like buying a house or buying stocks, we have a formal process for making rational decisions i.e. we consider all the options available to us, their outcomes, how advantageous each outcome would be and consider the probabilities of each of these options. In reality, do we do that?

Economists and authors of Animal Spirits, George A. Akerlof and Robert J. Shiller, point out that many of the decisions we make more intuitive rather than analytical. This highly recommended read joins a growing body of written work in economics that chips at the foundation of classical economics.

Nobel laureate and professor of economics at the University of California, Berkeley, Akerlof and best-selling author (The Subprime Solution and Irrational Exuberance) and Yale Economics professor Shiller explore the economics and psychology and try to incorporate all of real human behaviour’s quirks and irrationalities into the core of economics.

This alternative framework is an effort to reanimate the original vision of John Maynard Keynes. Post 1930s Great Depression, Keynes’ 1936 masterwork “The General Theory of Employment, Interest and Money” pointed out that market economies could suffer long periods of high unemployment and low output unless government stepped in to supply the necessary demand.

By the 1940s, Keynes theory became gospel and his principles regarding the role of fiscal and monetary policy in fighting recessions became fully incorporated into the thinking of economists, politicians and academics. This fiscal wisdom is today reflected in Barack Obama’s US$787bil programme.

However, another more fundamental message of Keynes’ General Theory was cast aside. While Keynes appreciated that most activity results from rational economic motivations, he believed that much economic activity is governed by animal spirits.

People have non-economic motives and they are not always rational in their pursuit of their economic interests.

In Keynes’ view, these animal spirits are the main reasons why the economy fluctuates and also the main cause for involuntary unemployment.

This watering down of Keynes’ original theory in order to gain quick converts to fiscal policy has had unfavourable long-term consequences. Latter day New Classical Economists, whose theories are now the centrepiece of modern macroeconomics, were of the view that we should not consider animal spirits at all.

The belief in free markets, that governments should not interfere with people in pursuit of their self-interest, has influenced national policies in England and the US during Margaret Thatcher and Reagan’s time respectively.

Three decades later, we are experiencing the troubles this mantra has spawned.

The authors explain that “just as Adam Smith’s invisible hand is the keynote of classical economics, Keynes animal spirits are the keynote to a different view of the economy – a view that explains the underlying instabilities of capitalism.” Keynes’ view of the government’s role in the economy was very much like what we are told in parenting advice books.

Parents who are too authoritarian risk superficially obedient children who rebel later but parents who are too permissive will have children who do not set proper limits for themselves. Hence, the proper role of the parent is to set the limits so that the child does not overindulge her animal spirits but those limits should also allow the child the independence to learn and to be creative. Keynes’ view was that the role of the parent/the government is to create a “happy home”.

Capitalist economies, while creative, when “left to their own devices will pursue excesses as current times bear witness.” Hence, the proper role of the government is to “set a stage that gives full rein to the creativity of capitalism…but it should also countervail the accesses that occur because of our animal spirits.”

Animal Spirits rebuilds a case for a more robust, behaviourally-informed Keynesianism by describing the five different aspects of animal spirits (i.e. confidence and fear, bad faith and corruption, a concern for fairness, money illusion.

The book provides a plausible explanation on how we have fallen into the current crisis.

Although it calls for a reworking of standard economic theory, Animal Spirits is not a difficult book to get through. It is short (176 pages), written in an easy conversational style, peppered with interesting anecdotes and historical references as well as elegant arguments instead of only elegant equations that dominate books of this genre. As the book cuts through a lot of technical mumbo-jumbo, relegating the details to a good set of footnotes and additional references at the end of the book, both general readers and serious ones will be engaged and drawn in.

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