It may come as little surprise to the layman that human beings do not always act rationally. Can a species which has produced everything from human sacrifice to Dude, Where’s My Car? really be regarded as entirely sane?
The humanities and social sciences take account of irrational behaviour: even as they seek patterns, they acknowledge that human minds constantly outwit the power of numerical analysis.
But it seems that many economists, who base their quantitative theories on a hypothetical human who acts according to “rational self-interest”, are only now rediscovering the fact.
In their book Animal Spirits, George A Akerlof and Robert J Shiller argue that economists, as they interpret broad movements in areas such as inflation, unemployment and savings, take too far the assumption that people and markets are logical.
Akerlof is a Nobel prizewinner, while Shiller is also the author of Irrational Exuberance. Both are economics professors, and after lifetimes of studying the field, they argue that policy has been too heavily based on quantitative interpretations of the theories of John Maynard Keynes.
While his work has enabled governments to offset some shocks to economies, they say it has also been misinterpreted so that governments have become “permissive parents” to markets they trust to achieve their own balance.
Instead, the pair urge a re-reading of Keynes, resurrecting a passage from his General Theory of Employment, Interest and Money: “Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism, rather than mathematical expectations… Most, probably, of our decisions to do something positive… can only be taken as the result of animal spirits.”
Taking “animal spirits” as their catchphrase, they
say five aspects of human thought should be taken into account when formulating how people are likely to behave: confidence, the perception of fairness, corruption and bad faith, money illusion and stories.
In their portrait, the effects of market changes are compounded not only by feedback mechanisms – such as investors fleeing from shares whose price is falling, causing it to fall further – but also by beliefs and stories that spread among a population.
Results of these “animal spirits” include the pensions gap, generated by an irrational failure to save. They also include the pattern of boom and bust: indeed, Akerlof and Shiller even suggest that crises “are mainly caused by changing thought patterns”.
While the pair seek to present their theory as revolutionary, the field of behavioural economics is not new: it has been in existence at least since the 1970s, and won Daniel Kahneman and Vernon Smith a Nobel prize in 2002.
But where Kahneman and Smith focused on experimental methods, Akerlof and Shiller call for a re-thinking of macroeconomic policy on the basis of the “animal spirits” they identify. In some areas, they make specific recommendations for adjustments – on the balance of inflation and unemployment, for instance, in line with their analysis of inflation expectations.
However, the concept of “animal spirits” frequently seems an uncomfortable umbrella under which to place a set of disparate ideas. And unlike quantitative models, theories of psychology cannot (so far) be used to predict the future or calibrate monetary policy.
Specific policy tweaks are one thing. But while Akerlof and Shiller call for a wider overhaul, they both freely
admit they do not have the recipe for that change. More
worryingly, their suggestions for changes err on the authoritarian side.
Comparing low savings rates in America with high ones in Asian countries, they praise savings in Asia as an engine of economic growth (a refreshing change from advocates of never-ending consumption). They attribute high savings rates in Singapore and China to “different cultural understandings of how one should behave towards consumption and saving”.
Yet they acknowledge that the Singaporean government’s Central Provident Fund required all citizens to place up to 25% of their savings in the fund until retirement, giving the lie to their own theory that “stories” motivated these citizens to save.
Akerlof and Shiller indicate that their faith in the power of governments to mend economies is strengthened by the “animal spirits” theory, despite the current chaos.
“A world of animal spirits gives the government an opportunity to step in,” say the authors. “Its role is to set the conditions in which our animal spirits can be harnessed creatively to serve the greater good. Government must set the rules of the game.”
To an economics outsider, the argument does not inspire confidence. It seems the pair back greater government intervention, rather than checks and balances – almost as if they wish to control those elements of society that quantitative theories cannot describe.
Yet the financial crisis gives little credence to the idea that governments will act as a curb on financial excesses:
it has only exposed their closeness to financial institutions and their tendency to overlook corruption.
Indeed, the lack of self-reflexiveness is where Akerlof and Shiller’s argument ultimately fails to convince. They neglect to address the fact that, as the crunch has shown once again, governments and economists are just as susceptible to “animal spirits” as the rest of us.