Animal Spirits — George Akerlof and Robert Shiller

Multipliers, illusions, and narratives

Standard economic theory thus far provides little room for animal spirits. In pursuit of mathematical elegance, their models prescribe rational, economic motivations to all decision makers. We know, of course, that to understand the gyrations of market systems, we have to appreciate the dynamics of psychology that move our ideas, beliefs, and wants.

Indeed, this is the contention of economists George Akerlof and Robert Shiller in their book Animal Spirits, published amidst the Global Financial Meltdown. In it, the authors highlight four behavioral factors to account for in socioeconomic systems: (1) confidence multipliers; (2) fairness and corruption; (3) money illusions; and (4) collective narratives.

True, none of these concepts are markedly new to economic commentary. They were popularised in the early twentieth century by John Maynard Keynes and other economists. And many practitioners today, like Howard Marks (see Mastering the Market Cycle and Oaktree Memos), have already incorporated animal spirits into their mental models.

Each idea, however, is well worth discussing in brief detail – to appreciate how human psychology can affect our micro-decisions and collective behaviors. So, let’s begin first with confidence.

Confidence multipliers

Economic students should be familiar with the Keynesian multiplier: that each dollar of additional spending is amplified in the economy through the circular flow of expenditure. This theory helped in part to explain the Great Depression, where the drop in consumption in response to the stock market downturn reverberated across the financial and economic system (although an inexperienced Federal Reserve at the time added further to the woes).

Akerlof and Shiller point out that there exists a confidence multiplier as well. It “represents the change in income that results from a one-unit change in confidence”. Put another way, confidence affects savings, investments, and credit, which influences national income, which affects confidence in turn, and so on.

Confidence in standard theory, by contrast, is a rational process. It says that economic agents combine information with preferences to form beliefs about their optimal course of action. But it’s not obvious as to how people should incorporate an expanding sea of information for rational decision-making. We’ve seen in practice, for example, how information overload can reshape sentiment and confidence with time.

Rational sense, rational process?

Akerlof and Shiller believe that financial theory is yet to make “rational sense” of the market’s moods and swings. Market prices and corporate investment are more volatile than national gross domestic product; and appear too erratic to reflect economic fundamentals alone (some models attribute this to an undershooting or overshooting in prices, as markets incorporate information imperfectly over time).

Animal spirits, confidence multipliers, and feedback loops, the authors argue, must form a part of our understanding. Keynes himself paralleled market speculation to a beauty contest, in which each participant tries to guess what they believe others believe is the most beautiful stock. This regressive loop can generate vicious circles when collective confidence and narratives converge in the same direction.

Likewise, we cannot think about markets and confidence in isolation from the rest of the financial system and real economy. Rising asset prices may improve confidence and credit flows. It may encourage households to spend more, and businesses to absorb greater risks. This, in turn, may boost economic results – adding further to prevailing asset prices, confidence, and credit flows. Even if you sit out the next financial fad, you cannot escape its hooks into the real economy.

Fairness and corruption

Standard theories, like the neoclassical theory of wage determination, are also quiet on the role of fairness in market systems (although I sympathise with theorists who are expected, fairly or unfairly, to explain everything in a single model). Here, Akerlof and Shiller recommend we look to contributions from sociology. We know, for example, how charisma, outrage, and reciprocity can influence the economics of negotiation. Not all of it is rational calculation either. Norms and cultures help individuals and enterprises to shape and simplify the process.

If I were to generalise further, I’d say people think not only about absolute maximisation, but about relative positions too. In this way, their sense of fairness and rightful opportunity can slip into a fear of missing out or potential loss. In The Psychology of Human Misjudgement, Berkshire Hathaway’s Charlie Munger calls this deprivation super reaction tendency.

Indeed, self-destructive price wars are sometimes the result of bull-headed competition for relative market share at all costs. While microeconomic theory can account for some of these behaviors, I suspect behavioral economics, psychology, and sociology will have much more to say about this in the near future.

Widgets and snake oils

If fairness rests on one end, corruption ferments on the other. Runaway markets remain a hotbed for snake oil, Ponzi-schemes, and accounting scandals. Financial shenanigans, the authors say, tend to rise and fall with the booms and busts of market cycles. Enron and Madoff Securities are case in point, in part because there’s nowhere to hide once credit and confidence finally recedes.

As Ben Bernanke, Hank Paulson, and Tim Geithner observe in Firefighting, financial risk and predatory behavior tends to migrate to corners where capital, enthusiasm, and regulation are most unrestrained. Unprincipled behavior, Akerlof and Shiller say, “may also reflect a social osmosis”. While prudence and regulation may follow the bust, financial amnesia, irrational exuberance, and excessive risk taking tend to underpin the boom.

“Capitalism fills the supermarkets with thousands of items that meet our fancy. But if our fancy is for snake oil, it will produce that too. … This theme in the minor key has been forgotten. Yes, capitalism is good. But yes, it has its excesses. And it must be watched. … We need to realize that the stories people tell themselves about the economy exaggerate. There is a new need to protect them from these exaggerations. … The stage should give full rein to the creativity of capitalism. But it should also countervail the excesses that occur because of our animal spirits.”
George Akerlof and Robert Shiller. (2009). Animal Spirits: How Psychology Drives the Economy, and Why It Matters for Global Capitalism.

Money illusion

Of the factors that Akerlof and Shiller discuss, the illusion of money is probably the least talked about in popular commentary. Standard economic theory says that rational people care only about the relative purchasing power that money affords them – not its nominal amount. That is, we think about money only in terms of the needs and wants it can afford us.

While this argument appears reasonable for the most part, much of commerce, from our accounting standards to taxation system, takes place in nominal terms. Sure, we could adjust for inflation. But how often do you see wage or debt contracts account for inflation in practice?

Shiller’s classic paper – Why Do People Dislike Inflation? – reminds us that economists and non-economists perceive the consequences of inflation in very different ways. Many people associate inflation with a downward “standard of living effect”, along with “issues of exploitation, political instability, loss of morale, and damage to national prestige”. Right or wrong, such beliefs affect our attitudes, which shapes our behavior and reality, which affects our beliefs in turn.

The money illusion may, for example, influence real estate price cycles. When our grandparents talk about the manifold increase in housing prices, many of us, I suspect, fail to adjust for decades of inflation. This may warp our beliefs and expectations. But as the Global Financial Crisis or Japan’s Lost Decade show, the real, risk-adjusted returns on real estate are far from a guarantee. ‘Safe as houses’ can be a dangerous fallacy.

Collective narratives

In Sapiens, Yuval Harari describes myth making as a central feature of humankind’s history and development. From religion to ideology, stories help groups to organize and cooperate. Narratives play a similar role in the movements of markets. Media agencies, for example, are compelled to turn random, daily gyrations in the stock market into headline narratives. And retail and institutional investors alike cannot help but follow these sound bites.

Invisible roller coasters

Once again, standard economic theory is light on narrative making. The efficiency and allocative powers of free, perfect markets relies on the quality and completeness of information. We know, of course, that the real world is tumultuous. In the face of uncertainty, many turn to instinct and the herd, not rational calculation.

Narratives provide the collective with a social tool to navigate uncertainty and simplify competing possibilities. Such stories, Akerlof and Shiller say, “are like viruses” that “spread by word of mouth”. The most contagious and sticky of narratives can galvanise entire social systems.

In this way, confidence and narratives are interlinked. During the dotcom and subprime bubbles, it was difficult to know where we were on the “rollercoaster” because the stories were so dominating. We have to remember that shared narratives play as much a role in finance as they do in politics, religion, and our childhoods.

Credit and confidence targets

By now, you can start to see how confidence, corruption, illusions, and stories, alongside economic motives, might combine to generate extreme behaviours in the marketplace. Akerlof and Shiller remind us that “the twin crises of confidence and credit” are the usual culprits behind most booms and busts. Very rarely can companies, markets, and economies sustain growth born from unsustainable beliefs and foundations.

More spending, lower interest rates, and less taxes are common prescriptions to financial crises. Indeed, fiscal stimulus is necessary to restore aggregate demand and full employment. But weak demand, the authors say, is only part of the problem. As we saw with the Global Financial Crisis, governments have to grapple with the ensuing credit crunch as well.

On this front, Shiller and Akerlof recommend a credit target to ungum our financial plumbing; and to alleviate shrinking fiscal multipliers during recessions as households and businesses cut back on spending. The communicative powers of credit targeting, I think, could also help with market psychology (although it may also promote moral hazard risks too).

Shiller and Akerlof talk through different mechanisms – like the discount window, direct capital injections, and direct credit via government-sponsored enterprises. I won’t go into their advantages and drawbacks here. But I am curious if governments are clear-headed enough to apply credit targeting during episodes of mania and excess.

Elite athletes

Finally, we can learn a bit, I think, from the psychology of elite athletes. That is, to avoid over excitement after extended wins, and despondency after protracted losses. But the engineering of expectations and confidence is risky business. Policymakers and central bankers have to be good students of history. They have to maintain a detached sense of the prevailing spirits.

Unfortunately, few governments and institutions are as disciplined and organized as elite athletes. Given the inertia of politics, and our propensity for herding, manias and panics are likely to remain a mainstay. It seems most unwise then to neglect our animal spirits in our understanding of the world.

Animal Spirits and Market Psychology — George Akerlof and Robert Shiller