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.

New Expectations in Monetary Policy

The ridiculous entries in Lolfed.com and reactions it receives (from Paul Krugman no less) demonstrate the decline in confidence that Americans have come to regard both the US Fed Chairman Ben Bernanke and Treasury Sec. Hank Paulson with. So much so that the unexpected announcement by the Obama transition team of the appointment of a new treasury chief in the person of current NY Reserve President Timothy Geithner was all that was needed to generate a much needed lift late Friday after a near disastrous week on Wall Street.

Here in Australia, the monetary and fiscal authorities have been keen to do a similar two step as the Americans with the same limited effect. Back in May of this year, the RBA was put under scrutiny over its decision to raise interest rates. Having shown its audacity in doing so during the election season that toppled the Howard government, it was given the imprimatur by Treasurer Wayne Swan who in declaring a war against inflation since taking office set the tone for monetary and fiscal policy to be on coordinated footing.

It didn't matter that Joseph Stiglitz, a Nobel Prize winning economist had been appearing on local TV regarding the Australian situation on inflation and the policy on inflation targeting which he predicted would be abandoned within five years because of its inefficacy to deal with the importation of inflation through petrol and food prices.

The defense that it was the commodities driven terms of trade boom generating price inflation notwithstanding, the oracle of Stiglitz has been proven true in less than six months with the higher than anticipated RBA cut of 100 basis points and further cuts in the offing, despite inflation exceeding the upper band of the 2 to 3 percent range. Why is it then that macroeconomic policy makers often fail to get their settings right?

Could it be that they are still operating under a misguided view of the world that sees agents as purely rational? To what extent do adaptive rather than rational expectations play a role in resolving the problem?