Have you ever wondered what really drives the economy and why it undergoes periodic booms and busts? In their book Animal Spirits, Nobel laureate economists George A. Akerlof and Robert J. Shiller identify five psychological factors or aspects (confidence, corruption, money illusion, fairness and most importantly, stories) of our 'animal spirits' responsible for the economic growth, recessions and financial crises we encounter.
"Animal spirits" is a phrase coined by legendary British economist John Maynard Keynes who recognised the role of human emotions and irrationality in making economic decisions. However, the authors argue that as economics became more quantitative, mathematical and rational, we started ignoring our 'animal spirits' until eventually leaving them out of our economic models completely.
Consequently, the world's largest economies, especially those of the US and the UK, heavily deregulated their economies and ended up in periodic economic turmoil like the dot-com bubble in 2001 or the subprime mortgage crisis in 2008. The authors maintain that our animal spirits have yet to be recognised entirely and encourage policymakers to consider while making decisions or designing policies.
The first part of the book explains the five aforementioned attributes of animal spirits in depth. The most important psychological factor driving economies is the stories we tell each other and ourselves. The authors say that our minds are conditioned for narrative-based thinking, and as a result, we remember stories better than facts and figures. That is why our culture is essential in determining how we make decisions and why 'The American Dream' became a self-fulfilling prophecy.
Similarly, confidence derived from stories is a crucial component of our economic decision making. Consequently, leaders who can craft the best narrative can often inspire excellent outcomes from their people by bolstering confidence.
Moreover, entrepreneurs and business leaders often make big decisions and take risks based on intuition rather than rational cost-benefit analysis. As a result, consumer and business confidence can create feedback loops resulting from the multiplier effect to cause economic booms and recessions.
For example, the fear of an incoming recession may compel consumers to cut spending and save in fear of losing their jobs, which may trigger the recession due to falling aggregate demand.
Additionally, money illusion or the inability to understand inflation can influence people into making bad decisions. For example, although an economist may accept a wage cut during deflation as the purchasing power of his/her salary remains the same, most people would strongly oppose any wage reductions (causing wage-price rigidity) as it is perceived as 'unfair'.
The authors show how prominent money illusion is in accounting, wage contracts, and stock prices (where everything is recorded in nominal terms rather than in real terms) despite standard macroeconomic theory discounting it.
Moreover, the book identifies fairness as a critical factor driving the economy and encourages policymakers to be mindful of 'fairness' when designing policies. In that regard, the book shows how there is a long-run tradeoff between inflation and unemployment due to the wage-price rigidity as trade unions oppose unfair wage cuts.
Finally, the book recognises the role of corruption and/or acts of bad faith as a key contributor to economic fluctuations by referring to historical financial crises caused by the corrupt practices of financial institutions.
In times of confidence and limited government oversight, the authors remind us that bad actors spread overconfident stories and take advantage of the masses to create economic bubbles based on speculation.
The second part of the book answers eight questions regarding central banks' role, involuntary unemployment, economic recessions and their causes, tradeoffs between inflation and unemployment and the volatility of stock markets and real estate prices that standard economic theory cannot.
The authors use a combination of the five established attributes along with empirical data and historical references to expertly answer all these questions in an engaging and anecdotal method.
The authors conclude by emphasising the need for macroeconomic theory and government policies to incorporate animal spirits. Although it cannot answer exactly how to do so in a quantitative way, it certainly points towards the right direction for the field to further develop.
Even though this book is a bit dated (first published in 2009 in the aftermath of the 2008 financial crisis), the challenge of quantifying psychological factors remains challenging to this day.
This book is not for casual readers despite what its colourful and cartoonish cover may suggest. It's a low-key introduction to Keynesian economics with plenty of notes and references for further study.
There has been some criticism regarding the book promoting a paternalistic role of the government. After reading this short yet serious book, readers will understand how the economy works and use the psychological attributes identified in the book to explain how most economies operate in their respective business cycles.
The authors are remarkably pro-capitalist while warning us of its many pitfalls and how bad things can get if we let it run unsupervised in a free market.
"Capitalism fills the supermarkets with thousands of items that meet our fancy. But if our fancy is snake oil, it will produce that too," is an apt summarisation of the authors' stance in that regard.
(Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism; Edited by George Akerlof and Robert Shiller, Princeton University Press, pp. 264, $24.95)