Sustainable Pace

April 25th, 2009

Animal Spirits
(Robert Shiller and George Akerlof, 2009)

I'm an avid reader of the weekly newspaper "Die Zeit". In a recent edition they started a series of articles, called "Denker für morgen", focusing on people who are thinking about nothing less than the future of mankind. The first article in this series was on Robert Shiller, an american economist. He believes that markets need to be regulated in order to achieve a supply and demand balance, and to prevent a collapse.

This article made me curious about a recent book he co-authored, "Animal Spirits" (the other author is George Akerlof). It's based on the assumption that classic economic models insufficiently describe current macroeconomic events: in these models, humans base their decisions on rational economic reasoning, we call them homo oeconomicus. But according to the authors, humans hardly ever decide rationally, they are influenced by animal spirits. These animal spirits describe factors that influence decisions of market members, the authors list "confidence", "money illusion", "stories", "corruption" and "fairness".

Sustainable Pace

Confidence (or the lack of) is a major animal spirit, and the easiest to explain: in boom phases people become over-confident in the economy, and in recession-phases under-confident. In the late 1920s people invested like mad in the stock market because they were overconfident, not because they actually felt that the stock prices reflected an actual value.

Just take a look at stock prices. What does the price actually represent? The value of a company? Or, what other people think is the value of the company? Or even further, what people think that other people think is the value of the company? This could go on forever. The authors compare the stock market to a beauty contest: if you had to bet on the winner in a beauty contest, you would go for the one you assumed most other people would vote for.

I also liked the chapter on stories: It is assumed that the human brain operates in a way that it memorizes stories best (that's the reason people employ Eselsbrücken). Therefore, a story can be processed more efficiently than complex and abstract issues like macroeconomy, and people thus easily believe in a story rather than trying to understand a complex system. An example: The recurring real estate bubble is (beyond other factors) fed by stories, like this one: real estate markets are an ever-growing market due to the limitation of space. It is assumed that buying real estate will only become more expensive in the future. So it appears reasonable to invest in real estate, although statistics disprove this assumption.

It's interesting to note that animal spirits not only determine the way we perceive the economy, but furthermore affect it directly.

The authors continue with eight economic phenomena, which cannot be described by classical economic models, but can very well be explained if animal spirits are included. Some are a little too technical for an economics-illiterate like myself, some seem a little superficial. I would have loved to see an actual basic (mathematical) model that uses animal spirits, as I can imagine how convenient the assumption of a homo oeconomicus is, and how complicated things get if these additional factors are included, and can feed back into each other.

The authors conclude by making the following point: Capitalism is very efficient in producing supply for all kind of demands. But if your demand is for snake oil, it also provides snake oil. This is why we need regulations. Taking animal spirits into account could lead to models that are more accurate in depicting the real world, and from these models we can learn which regulations can avoid disturbances like the current recession (which is also dealt with in a previous chapter).

At about 180 pages (not including the appendix), the book is a nice read, and it seems relevant to me. After all, it's a good reminder that we are indeed just monkeys in suits. If you want to read it, let me know, and I will send it to you. Books love to travel, they hate shelves.

Update: I no longer own this book.