Review of Animal Spirits by George Akerlof and Robert Shiller (Princeton University Press)

by Richard BRONK
Visiting Fellow, LSE

It is always exciting for an academic author when their new book seems to be part of a new tide in the intellectual history of their discipline. So, it was with delight, as author of The Romantic Economist, that I embarked on reading Akerlof and Shiller’s Animal Spirits – also just published. Here were heavyweight reinforcements for the long overdue assault on the myopia of the economics profession concerning the role of sentiments.

In most respects, I was not disappointed. For one thing, ‘Animal Spirits’ accords beautifully with one of the main recommendations of ‘The Romantic Economist’ (and Alfred Marshall, for that matter): it is written in what Wordsworth called a ‘language really used by men’, so that its arguments and assumptions are readily accessible to specialists and non-specialists alike.  For another, the book presents a rigorous case for the importance of ‘confidence multipliers’ and ‘stories’ (or narratives) in explaining recent market behaviour; and for the role of ‘fairness’ and ‘money illusion’ in preventing wages from falling in recessions to the market-clearing rate. Indeed, the book is a very useful practical primer for policy-makers and practitioners (as well as academics) on most aspects of the current crisis. Finally, Akerlof and Shiller make a compelling theoretical case for incorporating non-economic motives (and responses that do not accord with the axioms of rationality) into macro-economic theory.

There are many particular insights: for example, that the fateful switch in 2000-2007 from equities to investment in real estate (and credit) was partly caused by loss of faith in the accounting of the corporate sector following the Enron scandal; and that the 1930s depression was partly so protracted because companies feared to invest as a result of uncertainty about the political reactions of governments to public disgust with capitalism.

There are also a few lacunae in the argument. In particular, the authors are unfair to Adam Smith’s model – though in a very interesting way: they ignore the key role in society that Smith assumed for moral sentiments, as well as his emphasis in ‘The Wealth of Nations’ on sentiments such as fear and unease. Smith was much more concerned about the dangers of the visible hand of government causing debilitating fear and unease among entrepreneurs than he was eloquent about the optimality of the invisible hand of the free-market; and this lesson needs to be remembered. For Akerlof and Shiller, the destabilising nature of ‘animal spirits’ justifies government intervention and this must be correct up to a point; but, as Smith reminds us, if this intervention is seen as arbitrary and unpredictable, it may be self-defeating and undermine the confidence of savers and investors alike. Furthermore, Smith’s explicit and implicit assumption that powerful moral sentiments underpin market interaction is also important. As the Romantic philosopher and poet Coleridge argued, economic rationality is the fragile product of a necessary balance between the ‘lust of lucre’ and moral restraint. As many have argued since (from Ruskin to Fukuyama), moral sentiments (like loyalty and trust) are positive stabilising forces that boost confidence and efficiency – particularly in conditions of uncertainty. These good sentiments perhaps receive insufficient attention in ‘Animal Spirits’.

I have a couple of other quibbles with this excellent book. First, it seems odd to lump together confidence effects, a sense of fairness, corruption and anti-social behaviour, money illusion and cultural stories under the catch-all rubric of ‘animal spirits’. Some are basic emotions, some moral (or immoral) sentiments, and others social or cultural frames of reference. This is not merely a semantic point: the differences between these disparate exceptions to economic rationality suggest differences in where we should look for answers – psychology, applied ethics and sociology. It is true, though, that there is something (not acknowledged by the authors) that unifies most of the spirits discussed: they were identified in general terms by the Romantic critique of rationalism. I would argue that this critique provides the lost conceptual context for most of Akerlof and Shiller’s points and one that could help further develop and refine them. In particular, it would suggest quickly the ghost at the banquet – the role played by the imagination. For imagination not only plays a role in many of the framing issues discussed (for example, the young can hardly imagine themselves being old, let alone the interests they will then have); imagination and creativity also play a key role in causing uncertainty in markets. Many of the inflection points in markets are when key players imagine new options, create new goods or create new dominant images of the future.

Finally, Akerlof and Shiller make a ringing call for macro-economic theory to take animal spirits seriously – and so it should. But there are two ways of doing this: one is to co-opt into standard models the findings of psychology and sociology where they suggest systematic regularities (the option favoured by the authors); the other is to make clearer the boundaries of applicability of standard models and the need to supplement them with models from other disciplines when dealing with many facets of the economy. Which route economics takes matters. It is possible that disciplined cooperation between pure paradigms from different disciplines might be more fruitful in the end than continual reengineering of the standard paradigm in economics. The ‘cooperation between disciplines’ option would, though, require economics to give up its imperial pretensions to explain everything in the socio-economic sphere on its own.

This is the title of a terrific new book in MIT Press's Boston Review series, whose format is an opinionated essay followed by several replies. There is also an associated blog. The author of Africa's Turn is Edward Miguel, co-author of Economic Gangsters which I posted about a while ago. He is, as William Easterly puts it in a foreword, one of a new generation of thoughtful and non-ideological development economists. Miguel's theme – and this essay seems to have been written before the extent of the world recession became clear – is that there is reason for cautious optimism about many African economies. He includes Kenya, which he clearly knows well, despite the uncertainties arising from the post-election violence there.

He is very sensitive to the risks, especially for those countries which depend heavily on commodity exports – not just because of price volatility but also because of their associated 'curses'. Economists think of course of the real exchange rate effects, and also the scope for corruption. But as Miguel also notes: “Where oil appears, there arrive the armed forces of the industrial states.” (p52) He is also concerned about the impact of weather on crops, as the climate changes, and proposes a specific type of aid, Rapid Conflict Prevention Support, which would go to a country as soon as there was a major crop failure. Nevertheless, he remains on balance optimistic, mainly because of political and governance improvements in many countries in the past two decades.

The respondents also make some interesting points. I was most taken with Olu Ajakaiye's points about Africa's over-reliance on unprocessed commodities and the need for industrialisation. While reform of farm trade is vital – and a scandal that the EU, US and Japan remain so protectionist in these goods – it is clear to me that Ajakaiye is right to argue on the need for diversification into more value added activities. Agri-processing seems the natural place to start to me, as the produce is there and the skills of local workers are not far from what would be needed. I think this every time I get one of the 'Out of Africa' packs of macadamia nuts on a BA flight, and actually have come to believe there is a case for some infant industry protection for this sector, at least as long as we don't get the trade reforms. David Weil comments that institutional structures in many African economies such as price controls have served consumers but obviously hindered agricultural production.

I also cheered, unsurprisingly, Ken Banks's comment on the role of mobile phones, having done so much work on that myself (see the relevant Vodafone reports I've been involved with, and some others on my own website). Finally, Rachel Glennester argues that Chinese direct investment in Africa is overrated but the availability of cheap Chinese consumer goods such as bicycles or mobile handsets for consumers has been important. (There was an interesting FT article recently on the import of handsets from Hong Kong to Africa.)

The format of these Boston Review books is very appealing – this one was an interesting and thought-provoking but non-technical read for a train ride from Manchester yesterday.  The price is just under £10 – I think they'd sell many more at stations and airports if it were lower, at a price point somewhat higher than a glossy magazine. I hope to have chance to discuss the idea behind the series with someone at MIT Press for a later post.

Last Night's Comic Relief programme, with its wrenching films about suffering children, put me in sombre frame of mind, despite the jokes, as I'd just finished John Kay's excellent The Long and the Short of It. The book is stuffed with excellent investment advice, some of which I've even already implemented without thinking about it. But the chapter that set me thinking troubled thoughts is one about uncertainty, or Donald Rumsfeld's unknown unknowns.

John cites the famous passage from Keynes (Economic Consequences of the Peace, Ch 2, you can download the book from Gutenberg) which celebrates the glories of Britain's globalised and triumphant world on the eve of the First World War:

“The inhabitant of London could order by telephone, sipping his
morning tea in bed, the various products of the whole earth, in such
quantity as he might see fit, and reasonably expect their early
delivery upon his doorstep; he could at the same moment and by the same
means adventure his wealth in the natural resources and new enterprises
of any quarter of the world, and share, without exertion or even
trouble, in their prospective fruits and advantages; or he could decide
to couple the security of his fortunes with the good faith of the
townspeople of any substantial municipality in any continent that fancy
or information might recommend. He could secure forthwith, if he wished
it, cheap and comfortable means of transit to any country or climate
without passport or other formality, could despatch his servant to the
neighbouring office of a bank for such supply of the precious metals as
might seem convenient, and could then proceed abroad to foreign
quarters, without knowledge of their religion, language, or customs,
bearing coined wealth upon his person, and would consider himself
greatly aggrieved and much surprised at the least interference. But,
most important of all, he regarded this state of affairs as normal,
certain, and permanent, except in the direction of further improvement,
and any deviation from it as aberrant, scandalous, and avoidable. The
projects and politics of militarism and imperialism, of racial and
cultural rivalries, of monopolies, restrictions, and exclusion, which
were to play the serpent to this paradise, were little more than the
amusements of his daily newspaper, and appeared to exercise almost no
influence at all on the ordinary course of social and economic life,
the internationalisation of which was nearly complete in practice.”

This aapparently stable world of course vanished utterly, the certainties of the middle classes of central and eastern Europe overturned. John continues: “The future has not become any more certain.” And he goes on: “People who are today concerned about the Iraq war, China's rise or Climate Change, would not have been worrying about these issues 20 years ago. They would have been worrying about the Cold War, Japan's economic pre-eminence and the effects of AIDS.” His point is that we can't even frame the questions, never mind know the answers, when it comes to fundamental trends. No-one predicts most catastrophes. (pp126-128 of TLATSOI)

Without wanting to be unduly pessimistic, I did feel the shadow of fundamental uncertainty last October when it seemed possible the everyday payments and settlements systems would stop working, and stocked up on a few extra tins of baked beans and bottles of mineral water from Waitrose, in an inept 1914 bourgeois way. Looking at last night's films about the poverty and desperation of so many children in the UK and Africa last night made me ponder again what tensions would prove unbearable in this dramatically sudden recession. I did the bourgeois thing again and sent off my money, and looking at the staggering appeal total (£58m in one night), others did the same. Hope you all dug into your bank accounts too – if not, click on the link above!

By the way, for those interested in more, I posted previously about John's book and it's also reviewed by Jeremy Peat in the forthcoming edition of The Business Economist.

Time for a catch-up on some publishers' catalogues sent recently: Norton, Palgrave Macmillan and Edward Elgar.

From Norton's 2009 article, a couple of US-focused general titles which might interest economists. Flat Broke in the Global Market: How Globalization Fleeced Working People by Jon Jeter; and More Than Just Race: Being Black and Poor in the Inner City by William Julius Wilson. On the tech front, The Big Switch: Rewiring the World from Edison to Google by Nicholas Carr is out in paperback.

Palgrave Macmillan, in addition to the new Palgrave Dictionary of Economics featured earlier on this blog, has brought out a 2nd edition of the Krugman/Wells textbook and the 2nd volume of the Handbook of Econometrics. Another new title is Economics 2.0: What the Best Minds in Economics Can Teach You About Business and Life. Son number 1 is currently reading this (slowly) so I hope to persuade him to review it here later. There is also an introduction to Post-Keynesian economics by Marc Lavole, a subject in which there is presumably more interest than there was pre-crash, although I note that some P-K and heterdox economists are paradoxically bad-tempered about the mainstream adopting some of their views. I was particularly interested in Morals and Markets: An Evolutionary Account of the Modern World, on which I'll post at a later date as well as probably review for the next SBE journal. Also quite a few new titles in development economics and a tantalising one called Economic Returns and Economic Efficiency by Yew-Kwang Ng – a lot of my day job involves me in increasing returns industries.

Third up is Edward Elgar – always priced for libraries rather than individual purchases. A UK-specific title which caught my eye is The Political Economy of Financing a Scottish Government by Paul Hallwood and Ronald MacDonald, sure to stay a hot-button issue in UK politics. Also a collection of previously-published papers called Recent Developments in Monetary Policy edited by Alec Chrystal and Paul Mizen, featuring papers by all the top names in theory and practice – Bernanke, King, Bean, Lucas, Kydland, Goodhart etc – which might be a useful reference work. Finally, a lot of new titles on innovation and technology, for specialists in those fields.

“These heroes of finance,” Henrik Ibsen wrote, “are like beads on a string –
when one slips off, all the rest follow.”

This one courtesy of Oliver Kamm in the Times recently.