Monday, 9 March 2009

Shortish review of Animal Spirits

I've been looking forward to this book for a while. For one, it strikes me that we are at a bit of a turning point in terms of economic ideas, and a more behaviourally-informed view of the world looks likely to become more prominent. Secondly, I'm a bit of a fan of Robert Shiller, with Irrational Exuberance being a big influence on the way I think about stockmarkets. The book also is also very of the moment as it is pitched as in part sketching out a behaviourally-informed Keynesianism (the term 'animal spirits' being used in the General Theory).

The book is basically split into two parts - the first section runs though some key concepts that affect behaviour, and the second applies these concepts to a number of issues. The concepts that the authors highlight are confidence, fairness, corruption and bad faith, money illusion and stories. All of these are important factors as they show how human decision-making is not necessarily rational and self-maximising, as is often assumed in economics (I’m obviously simplifying massively here).

Just to take a couple of examples from this list, Akerlof has been involved in some very interesting research into how conceptions of ‘fairness’ affect market behaviour. Although it might be assumed that we are only motivated by our own interests, and fairness doesn’t really matter to us, actually ‘unfair’ behaviour can make (some of) us want to negatively reciprocate (retaliate), and willing to sacrifice our own potential gains in order to punish those acting unfairly. This has obvious implications (as Akerlof has argued previously) in terms of employment relations.

As someone who bangs on about narratives a fair bit, I was also very interested to see stories as one of the factors that they identify. This is a key part of Shiller’s analysis of bubble psychology too (the stories we tell each other about what is going on act as positive reinforcement/feedback). As a contemporary example of a story that has given validity to a certain type of activity, think about the number of people using the argument ‘my house is my pension’ as a way of explaining/justifying their punt on property investment. Actually this section of the book is pretty short, which is a shame as I think there’s a lot more in this issue.

Turning to applications, Akerlof and Shiller look at a number of policy areas where a behaviourally-informed view of economics might shed some light. Whilst often behavioural economics has appeared to have most to say about individual activity, Akerlof and Shiller are much more ambitious here, and tackle some big issues - why do economies fall into depression, why can't some people find a job, why are market prices and company investments so volatile, why do we get property bubbles etc?

So, for example, the section looking at depressions they not surprisingly put a lot of emphasis on the collapse of confidence. Confidence and the lack of it something that is, of course, widely talked about in terms of economic performance, but hard to quantify. However a review of press reports at the time of the Great Depression illustrates how common a theme it was (especially the need to boost confidence). Akerlof and Shiller also make the point that 'confidence' itself is a 'multiplier', having a reinforcing effect both when it is positive and negative.

The chapter on the volatility on financial prices is one of the ones that interested me most, as it brings together a number of strands explored earlier in the book. Obviously during an asset price bubble you can see a number of factors at play. As prices go up more people are drawn in, pushing prices up further. People then rationalise the bubble through stories (the internet has changed everything, there's a shortage of building land etc), they also get taken in by money illusion when hearing about appreciation in, say, house prices (something those involved in flogging houses are not keen to puncture). In all this to me provides a much more believable explanation of what goes on in terms of asset prices than much professional market commentary.

It's worth making the point here that Akerlof and Shiller are really calling for a bit of a new direction in economics, paying more attention to these kinds of social/psychological factors. This doesn't (need to) require junking existing approaches, as some of this stuff could be grafted on, however they seem to favour quite a shift. Whether there is enough in behavioural economics to bear the weight of such a transformation is a bit of an open question I guess. As I blogged previously, Chris Dillow has gone into much more of the proper detail.

Finally a bit about the style. In general, the chapters are fairly short and overall it has a very non-academic feel. Whilst that’s a plus point in general, you do wonder whether this might make it seem a bit flaky (which it isn’t) to some readers. Sometimes it does feel as if they could have gone into more detail. Hopefully the accessible style won't lead people to assume the ideas expressed are lightweight. This is definitly well worth a read.

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