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!

Smells like “Animal Spirits”

Neuroscience is helping to settle the debate over what caused the Great Recession: was it imperfect information or irrational behaviour?

A very amusing tussle among two high profile economists and an appellate court judge has been featured in The New Republic (available online). I am speaking of George Akerlof and Robert Shiller whose book, Animal Spirits, was harshly reviewed by Richard Posner.

The book addresses the question what causes asset bubbles to inflate and burst. Animal spirits, a term used by John Maynard Keynes has come to mean in its current incarnation “variations in the level of trust, storytelling and human interest, perceptions of corruption or unfairness, anger and optimism, social epidemics causing changes in gut instincts and feelings”.

A long list—which is why Posner’s critique that a reliance on such as set of specific contextual exemptions to the standard rational macroeconomic model is unnecessary. He contends incomplete information is sufficient to explain mistakes made by rational actors in assessing the risks and rewards of investing. Ironically, if anyone should be making this argument, it ought to be Akerlof who pioneered the study of asymmetric information for which we won the Nobel Prize along with Mike Spence and Joe Stiglitz.

Which view is worth its salt then?

Lately, the blogosphere has been buzzing with news of a study out of the University College London or UCL in which researchers have identified a gene that affects our economic decisions or perceptions of financial risk.

Previous studies have identified the amygdala (the same area of the brain used in processing emotions) as being involved in considering such decisions. The purpose of the current study was to determine if a particular gene known as the serotonin transporter, vital in affecting nerve connection in the amygdala, helps respondents deal with something called framing.

Generally, individuals are loss averse. For instance, being told that there is an 80 percent chance of surviving an operation would be the same as saying there is a 20 percent chance of dying. A person might decide differently based on whether the positive or negative side of an argument is used as a frame of referrence.

Susceptibility to this framing effect could be exploited by slick salesmen, mortgage brokers, credit officers, and the like to the detriment of investors and buyers (think of the sub-prime mortgage mess). For this reason, Colin Camerer and others recommend “cooling off periods” in which buyers could essentially renege without cost to them. This would remove the incentive for firms to engage in high pressure sales tactics.

The study found that individuals with a certain variant of the gene were more susceptible to framing. The good news is that genetics only accounts for 10 per cent of the variations in decisions. The remainder could be explained by life experiences, in other words, by personal and social learning.

The bottomline is that "animal spirits" a theoretical construct to explain irrational behaviour seems to find concrete verification in this study. With neuroscience, the behavioural argument that irrational decision making comes into play in market failures finds strong support.