Animal Spirits | Course Paper

Animal Spirits

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Princeton University Press •PRINCETON AND OXFORD

Animal Spirits

HOW HUMAN PSYCHOLOGY DRIVES

THE ECONOMY

,AND WHY IT MATTERS

FOR GLOBAL CAPITALISM

With a new preface by the authors

GEORGE A. AKERLOF

AND

ROBERT J. SHILLER

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George Akerlof is the Daniel E. Koshland Sr. Distinguished Professor of Economics

at the University of California at Berkeley; co-director of the Program on Social In-

teractions, Identity and Well-Being of the Canadian Institute for Advanced Re-

search; and a member of the board of directors of the National Bureau of Economic

Research. Robert Shiller is the Arthur M. Okun Professor of Economics at the Cowles

Foundation for Research in Economics and Professor of Finance at the International

Center for Finance, Yale University; research associate at the National Bureau of

Economic Research; and co-founder and principal of two U.S. firms that are in the

business of issuing securities: MacroMarkets LLC and Macro Financial LLC. The

views expressed herein are solely those of the authors and do not necessarily reflect

the views of these institutions.

Requests for permission to reproduce material from this work

should be sent to Permissions, Princeton University Press

Published by Princeton University Press, 41 William Street, Princeton,

New Jersey 08540

In the United Kingdom: Princeton University Press, 6Oxford Street,

Woodstock, Oxfordshire OX20 1TW

press.princeton.edu

Ninth printing, and first paperback printing, with a new preface

by the authors, 2010

Paperback ISBN: 978-0-691-14592-1

The Library of Congress has cataloged the cloth edition of this book as follows

Akerlof, George A., 1940–

Animal spirits : how human psychology drives the economy, and why

it matters for global capitalism / George A. Akerlof and Robert J. Shiller.

p. cm.

ISBN 978-0-691-14233-3 (hardcover : alk. paper)

1. Economics—Psychological aspects. 2. Finance—Psychological aspects.

3. Capitalism. 4. Globalization. I. Shiller, Robert J. II. Title.

HB74.P8A494 2009

330.12′2019—dc22 2008052649

British Library Cataloging-in-Publication Data is available

This book has been composed in Adobe Galliard and Formata

by Princeton Editorial Associates, Inc., Scottsdale, Arizona

Printed on acid-free paper. ∞

Printed in the United States of America

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Contents

Preface to the Paperback Edition vii

Preface xxi

Acknowledgments xxvii

introduction 1

Part One: Animal Spirits

one Confidence and Its Multipliers 11

two Fairness 19

three Corruption and Bad Faith 26

four Money Illusion 41

five Stories 51

Part Two: Eight Questions and Their Answers

six Why Do Economies Fall into Depression? 59

seven Why Do Central Bankers Have Power over the

Economy (Insofar as They Do)? 74

postscript to chapter seven The Current Financial Crisis:

What Is to Be Done? 86

eight Why Are There People Who Cannot Find a Job? 97

nine Why Is There a Trade-off between Inflation and

Unemployment in the Long Run? 107

ten Why Is Saving for the Future So Arbitrary? 116

eleven Why Are Financial Prices and Corporate

Investments So Volatile? 131

twelve Why Do Real Estate Markets Go through Cycles? 149

thirteen Why Is There Special Poverty among Minorities? 157

fourteen Conclusion 167

Notes 177

References 199

Index 219

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Preface to the Paperback Edition

The worldwide recession that was raging just as the hardcover edition of

this book was published in February 2009 seems to many observers, as of

this writing in October 2009, to be coming to an abrupt end. There are

definite signs of improvement. These observers could be right. Maybe

this is just another recession that will eventually be forgotten among the

annals of business-cycle history. But the theory that we lay out in this

book gives us cause to worry that we may be in a sick economy over much

of the world for years to come. Even the stirring success stories of the past

decade or so in the developing world, notably China and India, may see

their economic growth reduced to a disappointing level.

We think this because we have an unusual view of the economy, a

view that animal spirits, as we define them in the Introduction, drive al-

most everything. Animal spirits are more than just confidence as meas-

ured by confidence indicators. We argue that declining animal spirits are

the principal reason for the recent severe economic crisis. And, despite

the recent positive economic indicators, we see no clear indication that

these spirits are yet revived.

The news media are singularly lacking in any explanation for the re-

cent resurgence of the world economy beyond the improvement in

leading indicators, such as stock market prices and retail sales numbers.

The reasons the leading indicators have improved remain mysterious.

The stimulus packages put in place by most countries do not seem to

have been big enough to be held responsible. By many popular ac-

counts, the nascent recovery merely reflects a new willingness to spend

all over the world, as if that is a primordial force of the economy that

defies any further analysis.

There seems, to a reader of these accounts, to be an unseen force

propelling the economy, driving it into its periodic booms and busts.

But this perception is nothing new. In his 1873 book Lombard Street,

Walter Bagehot said that it seems that in an economic recovery busi-

ness “leaps forward as if by magic”:

Most people who begin to think of the subject are puzzled. . . . Why

should there be any great tides of industry, with large diffused profit

by way of flow, and large diffused want of profit by way of ebb? The

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main answer is hardly given distinctly in our common books of polit-

ical economy. These books do not tell you what is the fund out of

which large general profits are paid in good times, nor do they explain

why that fund is not available for the same purpose in bad times.1

Indeed, people are still puzzled today, in late 2009, by the sudden

improvement in our world economy. Textbooks of economics, while

vastly improved since Bagehot’s day, still do not give much enlighten-

ment about the ultimate drivers of the economy. They do not do so be-

cause the understanding of the drivers must lie somewhat outside the

traditional boundaries of economic research, in the realm of psychol-

ogy (as even Bagehot suggested), which is an intellectual tradition alien

to most economists. Macroeconomists have found it difficult to for-

malize the concept of animal spirits on their own terms, and so they

have largely neglected it.

The recovery we have been seeing of late certainly defies the analy-

sis of many economists who build structural econometric models and

see the sudden recovery as the result of “error terms” or “residuals” or

“innovations” in their equations. It defies the analysis of those econo-

mists of the “real business cycle” persuasion, who are in the habit of

thinking that all economic fluctuations are ultimately driven by exoge-

nous changes in “technology” and “productivity,” but cannot point to

a description of the cause of such a change right now. And of course, it

defies those who build purely statistical time-series models that quan-

tify past patterns in the data and calculate an optimal extrapolation of

recent wiggles in the same data.

Not only are we puzzled by the sudden turn toward recovery, we also

do not clearly see the longer-term threat to the economy. The longer–

term problem today remains that, after a terrible financial crash, the

coherence of our animal spirits and our economic institutions is shat-

tered. Humpty Dumpty is broken and cannot be put back together

again. We need a new egg. We have to reinvent our capitalist economy,

reestablish a genuine creative business spirit in people’s minds, and sup-

port their attitudes via institutions that really work and satisfy their def-

inition of justice. Instead, today we have, in their eyes, institutions “too

big to fail,” which are on life support from the government and our cen-

tral banks, operating as money-printing machines, and a general feeling

that business is corrupt and that the government support these institu-

tions receive has been arranged by evil lobbyists. We are facing the same

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problem today that we faced in the later years of the Great Depression

(described in Chapter 6)—business today is inhibited by uncertainty

about the future, about the tolerance of an angry public, about a dis-

affected labor force, and about what further government actions may be

coming.

The basic theme of this book is that animal spirits are the force that

drives all of this, and that to understand animal spirits we have to use

methodologies outside of traditional economics, leading us to other

social sciences.

We identified five psychological factors, in Chapters 1through 5of

this book, that we thought were of particular importance. They are

confidence, fairness, corruption and bad faith, money illusion, and sto-

ries. Changes related to all of these factors are the ultimate reason for

the boom that preceded the world economic crisis, for the crisis and re-

cession in which we have been immersed, and for the apparent begin-

nings of recovery. These phenomena cannot be understood in terms of

traditional economic theory alone.

The last item, stories, bears closer scrutiny. We argue in Chapter 5

that human-interest stories that give vitality and emotional resonance

to economic views drive animal spirits. Since economic expansions and

contractions in the modern world tend often to be worldwide phe-

nomena, these are not stories confined to any one country. The stories

spread amidst a growing world culture, from country to country, since

the same salience that works for a certain kind of story in one country

will generally work in another country as well. The names and places

change, but the stories are similar.

For example, the U.S. television show The Apprentice, which first

aired in 2004, near the height of the boom, features a real-world busi-

ness tycoon who leads a competition among promising young would-

be tycoons. The tycoon is a tough man who shouts belligerently “You’re

fired” at the losers, but who, in his own harsh and distant but ethical

way, serves as a mentor to help them all. The story shows the challenges

of a go-go business world, but it also affirms the quality of the people

who inhabit it and of young people’s ambitions to make it big there,

if they can just take the heat. The U.S. version features the American

real estate magnate Donald Trump, a colorful figure who was already

famous even before The Apprentice ever aired.

This story spread rapidly all over the world through local remakes

during a time of economic expansion. The only thing that producers

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needed to do to facilitate this spread was to substitute some locally fa-

mous tycoon or personality for Trump, to maximize the potential for

word of mouth and gossip in each local culture. In the United King-

dom, there came a version featuring British billionaire Alan Sugar and

an analogous program called The Rebel Billionaire with Richard Bran-

son. In Germany they substituted Reiner Calmund and called their

version Big Boss. In the Brazilian version, he was replaced by Roberto

Justus. In Colombia it was Jean-Claude Bessudo. The Turkish version

aired with Tuncay Özilhan. In Russia it was Arkadi Novikov. In Finland

it was Jari Sarasvuo. In Denmark, Klaus Riskaer Pedersen. In Norway,

Inger Ellen Nicolaisen. In Switzerland, Jürg Marquard. In India, Cyrus

Sahukar. In South Africa, Tokyo Sexwale. In Dubai, Mohamed Ali

Allabar. And in Indonesia, Peter Gontha.

With such contagion around the world, during the boom, of such a

motivational television story, is there any reason to doubt that conta-

gion of stories has economic significance, or that there could be world-

wide fluctuations in animal spirits? What kind of new story will gain

currency as we now go through the denouement of the financial crisis?

During the boom it was stories of people who were business and fi-

nancial geniuses that had us most inspired, promoting overconfidence.

After the bust, in 2008, it was stories about venerable financial institu-

tions on the verge of collapse, of shady characters drawing huge salaries

and bonuses at the expense of all of us. After the first signs of recovery,

in 2009, partly due to governments’ bailout and stimulus efforts, there

was a relative dearth of collapse stories. But, so far, we have not seen a

return of the confident stories, and sense of trust and opportunity in

business dealings, that we saw during the boom. Reestablishing these

stories is essential if we are to recover well from the severe economic

contraction, whatever those leading indicators may imply. If the econ-

omy is to grow from here, we must see the story evolving in positive

directions for economic cooperation and innovation.

The stories people tell are also stories about how the economy be-

haves. Indeed, it is in this last category, stories, where Animal Spirits

itself fits in, because the goal of the book is to give its own story about

how the economy behaves.

Its intent is to tell a more accurate story than the dominant one of

the past thirty years or so, ever since the free market revolution that

swept the world, under the leadership of Margaret Thatcher, Ronald

Reagan, Deng Xiaoping, Manmohan Singh, Mikhail Gorbachev, Brian

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Mulroney, Bertie Ahern, Carlos Salinas de Gotari, Fernando Henrique

Cardoso, Carlos Menem, and others. These stories, embellished by oft-

told vignettes of newly successful people, and in their mostly justi-

fied enthusiasm for expanded free markets, led to too much economic

tolerance.

Underlying this revolution is the powerful principle of the “invisible

hand”—that market forces should be the fundamental framework of

resource allocation. Recognition of this principle has produced the surge

of economic growth that has defined our age. And yet, today, with the

recent economic crisis, unregulated free markets are being questioned.

We believe that the unvarnished invisible hand story, although right in

a fundamental way, is wrong at the level of detail and approximation that

is necessary to explain what we need to know about macroeconomies.

The old story about capitalism is correct: it gives us what we think

we want. But capitalism does not act as its own policeman if we fail to

watch over it and give it proper directions. It actively, competitively,

seeks the most profit-maximizing opportunities. Capitalism will follow

such opportunities wherever they lead us.

That, of course, is relevant for the recent world financial crisis. The re-

cession, deep as it has been, has been a tragedy for people around the

world. They have been losing their jobs, their houses, and their dreams.

But recessions do have at least one silver lining: the cut they take into

economic life reveals how capitalist societies really work. To give one ex-

ample, Keynes’ General Theory, written in the heart of the Great De-

pression, gave us for the first time an understanding of how macro-

economies really behave. That is why it was so inspiring, prompting Paul

Samuelson to say, in 1946, that the Keynesian revolution, which appeared

during the Great Depression, has infected the thinking of virtually every

economist. But as the memory of the Great Depression has faded, so too

has an appreciation and understanding of Keynesian theory.

For the past year we have been seeing a great deal of excellent re-

portage on how we got into the current mess. Economists and Wall

Street financiers invented new ways to carve up debt obligations, such

as mortgages. They would not only “securitize” the mortgages and pass

them on, but they would securitize them into different “tranches.” De-

pending on the level of risk that people wanted to assume, tranches

could be divided into senior, mezzanine, or junior. These could then be

sold off, and different people would own different parts of the payments

from the different mortgages. Gillian Tett, author of the 2009 book

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Fool’s Gold, describes how initially this was an innocuous innovation

designed as an end run around the Basel capital requirements. Since tak-

ing on such mortgage debts seemed all but totally safe, the capital re-

quirement for holding them was very small. There was only one ques-

tion: who was going to hold the super-senior tranche, the remaining

fraction? This tranche, it was thought, would always pay at par, so it

would not have to pay much added interest.

Indeed, this is the same question that faces businesspeople in all

walks of life. Demolitionists, for example, who take down buildings to

make way for newer ones, are an important element of our economy,

and they illustrate well the shortcomings of unregulated capitalism.

Money can be made in demolition if one just demolishes the building

and sells off the scrap. But if one has to take care of the asbestos and

other environmental issues, by legal means, well, then it becomes diffi-

cult. So there is a powerful incentive for demolitionists to do some-

thing antisocial and illegally dump the asbestos, and a tendency all over

the world for demolitionists to be crooked. Honest ones generally can-

not survive, unless there are regulators watching the industry very

closely. Unfortunately, finance bears a resemblance to demolition in

this respect. In the early stages of the current financial crisis, financial

companies were able to insure the super-senior tranche. There were no

problems. But then this kind of mortgage securitization became more

widespread, demanding more and more placement of the securities in

investor portfolios. They were still able to sell the standard tranches at

prices that made it worthwhile, but not the super-senior tranche. And,

gradually, the banks and the shadow banks (which also borrow short

but hold long-term assets) came to think that their strategy was risk-

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