Shiller on Animal Spirits

Robert Shiller in his address to the RSA notes that the use of the term animal spirits or spiritus animales referring to animating feelings that drive our thoughts and actions has had a 2000 year history. Keynes used this term in the 1930s to portray the motives that lie behind the market and to explain the occurrence of depressions. He used this to argue for macro fiscal stabilisation policy to be used in conjunction with monetary policy in undermining fear that was gripping agents in the economy.

Thirty years later, the efficient markets revolution of the 1960s as espoused by scholars Modigliani and Miller converted many to the perfect markets hypothesis. This theory eventually gained ascendancy to thwart Keynesian macroeconomics and led to Thatcherism and Reaganism in the 1980s. Ultimately, faith in the assumption of perfect information that markets embody may have left markets exposed to extreme cycles of bubbles and busts, shocks which gradually have eroded confidence in the theory itself.

He speaks of his long association with George Akerlof the former president of the American Economics Association spanning over twenty years in developing behavioural macroeconomics and with Richard Thaler in developing behavioural finance. Over fifty years of research since Keynes has contributed to some extensions of animal spirits. The book uses the constructs so often ignored in the economic literature relating to:

• Empathy: a modern term that is distinguished from sympathy, relating to the way we are able to experience something that is happening to someone else, e.g. we feel left out, sad during an expansionary bubble if we are not invested in the market and are not profiting from it unlike those around us,
• Fairness: people are very alert to being slighted, i.e. sticky wage theory which is based on rigidities found in labour markets arises because people react negatively towards wage reductions,
• Corruption/bad faith: comes as a result of a lowering of standards (due to greed for example) i.e. the sub-prime mortgage meltdown has led to distrust towards the banks and legal contracts in general and leads to an unwillingness to transact,
• Money illusion: the way individuals react to inflation and deflation is based on the illusory effects of the value of money,
• Stories: social psychology tells us that the mind is organised around stories or narratives; people relate to stories rather than dry statistics.

Overall, these insights tell us that people are proximately rational. It is only under stressful conditions when undertaking decisions of significant emotional content that the animal spirits take over the rational mind. A memorable moment came when he quoted Larry Summers, chief economic advisor to Pres Obama who said that on the crucial policy issues of the day, none were being informed by economists.

In responding to the possible collapse of the banking system, governments in Britain and the US acted swiftly in order to cut off the oxygen from the narratives that were building to prevent stories that were proliferating of individuals affected by the possible bank collapses. Their accurate reading of the stiuation did not come from an understanding of behavioural economics but from their survival instincts.

When a member of the audience challenged his view that the crisis was driven not by these “panic” attacks but by the accumulation of reserves in China that supplied cheap money to US housing markets, Shiller pointed out that China’s massive savings rate developed over time. It came as a result firstly of the One Child Policy which was the Communist Politburo’s response to the narrative built up in the ‘70s by Club of Rome about the “limits to growth”; and secondly, by the story woven today of China’s resurgence in the global scene. The result of this has been the sense of nationalism and self-sacrifice that is justifying this need for savings. Fascinating stuff!