Akerlof and Shiller, Animal Spirits

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George A. Akerlof and Robert J. Shiller (Princeton University Press, 2009) tackles a broad swath of issues, both in the economy and in the discipline of economics. For instance, it takes aim at unfettered capitalism, at the model of the purely rational economic agent, and at economists who throw out everything that cannot be quantified. It stresses the role of animal spirits in the everyday economy and describes five of its aspects: confidence, fairness, corruption and antisocial behavior, money illusion, and stories.

I’m going to focus here on two interrelated themes: confidence and market volatility. Confidence, the authors contend, is not a simple binary idea that the future will be either rosy or bleak. (They therefore question the value of most measurements of consumer confidence. Instead of measuring animal spirits, these surveys “may only be reflecting consumers’ expectations regarding current and future income.” [p. 17]) Etymologically confidence also encompasses the notions of trust and belief. And trust and belief are not necessarily the outcomes of rational deliberation; indeed, “the very meaning of trust is that we go beyond the rational.” (p. 12)

Confidence varies over time. “In good times, people trust. They make decisions spontaneously. They know instinctively that they will be successful. They suspend their suspicions. Asset values will be high and perhaps also increasing. As long as people remain trusting, their impulsiveness will not be evident. But then, when the confidence disappears, the tide goes out. The nakedness of their decisions stands revealed.” (pp. 12-13)

The authors argue that, contrary to standard economic theory that portrays people as rational agents who weigh the pros and cons of all the options available to them before making a decision, most people base their decisions on what feels right or, as Jack Welch wrote, act “straight from the gut.” Decisions made in the face of uncertainty (where, as we know, uncertainty—unlike risk—cannot be measured) are intuitive. They hinge on whether or not we have confidence. Most business decisions, including our personal decisions about what assets to buy, “involve decision-making processes that are closer to what we do when we flip a pancake or hit a golf ball.” (p. 13)

Let me pause here to stress that the authors claim no relationship between confidence and a positive outcome. We know from behavioral finance that people tend to be overconfident in their ability to make correct decisions. That is, they may make decisions based on confidence, but (one level removed) their confidence in their ability to make decisions based on confidence is often unwarranted.

A second point that should be emphasized: the intuitive decisions that the authors laud are not uninformed decisions. They are the result of accumulated experience, often reflecting expertise. Take the pancake flipping example. I don’t particularly like pancakes and I am a singularly untalented cook. So, for me, deciding when to flip the pancake would be a pseudo-rational exercise that would probably have a sad end. By contrast, the person who had learned over time about the intricacies of making pancakes would “just know” when to flip it. The person trying to flip a house, on the other hand, might be confident but have no experiential basis for that confidence; he’s just riding the wave of general euphoria. His investment is likely to end as badly as my pancake.

And this brings us to the phenomenon of market volatility. No one, the authors begin, has ever made sense of the wild gyrations of markets. Not only can the experts not forecast market movements; “no one can even explain why these events rationally ought to have happened even after they have happened.” (p. 131) They are clearly not explained by fundamentals. The authors suggest that we have to look at the multiplier effect of feedback. First, and most obviously, there is price-to-price feedback, more popularly known as momentum. But “price-to-price feedback itself may not be strong enough to create the major asset price bubbles we have seen.” It is, however, complemented and reinforced by “feedbacks between the asset prices in the bubble and the real economy. This additional feedback increases the length of the cycle and amplifies the price-to-price effects.” (pp. 134-35) Animal spirits are at work everywhere.

And you want to know what animal spirits look like? The cover art for this book, reproduced above, is marvelous.