Here is my interview with Yale's Robert Shiller about his new book, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. The book, which Shiller wrote with George Akerlof of Berkeley, concerns departures from the full-employment economy: How do we explain the fluctuations of the business cycle, or the existence of involuntary unemployment? In answering these questions, Shiller and Akerlof turn to John Maynard Keynes's notion of the animal spirits: "the restless and inconsistent element in the economy" that is not easily explained by reference to rational actors with simple economic motivations.
Shiller talked about the legacy of Keynes, what Milton Friedman got wrong, and getting the stimulus package right. I posted my interview with Professor Akerlof yesterday.
Conor Clarke: The first question I have is one I asked George Akerlof. If I were to look through my textbook for why we have a fluctuating business cycle, the explanation would be something like, "because prices are sticky in the short-run." And I take it from reading Animal Spirits that you think that this explanation is insufficient.
Robert Shiller: Well that's a big, complicated question. It goes back to Keynes, really. Before Keynes people thought recessions were very simple: that wages were sticky and prices were falling -- this goes back a hundred years, the idea that wages are sticky even when prices are falling. It means that real wages are rising in a depression, so employers can't afford to hire additional people. Keynes thought that was oversimplified, but especially...ah, it's so complicated, you asked me an economics theory question.
You're allowed to give a complicated answer.
Well, one way to say it in simple terms is: Yes, there is some price stickiness. But the whole explanation of what goes on can't be found just there. We have factors that are driving the economy. These are the animal spirits that we named our book after: people are inconstant. They change. And if that's the case then sticky prices are not going to be the only effects on the economy.
Another broad question, but hopefully not so theoretical. Animal Spirits, and I guess your book Subprime Solution have a fair amount of psychology in them. So do some other recent books like Nudge and Predictably Irrational. Why this sudden interest in psychology?
Well, we have a problem in the University in that we divide scholars up into departments. Then we are asked to be at "the frontier of research," which is really hard to do. How do you be at the frontier of research? Have you ever tried it?
Nope, I have never tried it.
I'll tell you: the problem is, there are so many millions of people doing things. And every time you get an idea, you find someone else has already done it. So the incentive is to specialize really narrowly and get to know some narrow field really well. And that's how you know you're on the frontier, because you know the field, everything that's been written in this field.
But in many ways it's a bad incentive because it makes you too specialized. One way of specializing is to say, "alright I don't have time to read this psychology stuff, I'm just going to focus in on mathematical economics." This is a career route that many people choose and it yields some important results. But it is a narrow specialization, and many of the people that go down this route are not capable of understanding big events like the crisis we are going through now. You can't do that with just mathematical economics.
So the failure of economics as applied math is a reason why we are now looking toward things like psychology for more robust answers to questions about the business cycle?
There has always been a tendency for some people in the economics profession to want it to be a very pure discipline. It seems to push you back to thinking that everyone is being really smart. I think it is a little bit like Shakespeare. Shakespeare wrote these plays, and just about everybody seems so smart. Sure, you have a fool, but even the fool talks in verse. It's all perfect. And that's an appealing story and it becomes ego-involving for some economists. They really want to think the economy is perfect.
So how did this split come about? It sort of seems like there was a fork in the road, following Keynes's General Theory. Keynes wanted some of the psychological exploration that you and George Akerlof are exploring now, and then Milton Friedman came in and offered the natural rate of unemployment and rational expectations model -- and things like that sort of diverted economics from what might have been a discipline that included a lot more psychology.
I should add that -- and I don't know if I remember this right -- but I think Milton Friedman at some point in his career said he thought that rational expectations was overblown. That's not a quote exactly, but he was a complex man, as was Samuelson. It's a little bit hard to summarize the history of economic thought in simple terms.
But, I think it is true that I wouldn't blame it on... well I would probably blame it on Friedman. He did write Essays In Positive Economics in the nineteen fifties. It was short book, it was very influential, and it was used to justify the assumption that everyone is rational. And so, he wrote it, so I guess he is to blame for a lot of the rational expectations stuff. Not that I think that he necessarily believed all of what he said. But he had the famous example of the billiard player. Do you know this?
It comes from the book Essays in Positive Economics. Suppose we were asked to predict the behavior of a skilled billiards player. How would you do it? So we put balls on the table, and then your job is going to be to predict what his next shot will be. Well would you use psychology to do that? Probably not. Friedman said what you probably have to do is just assume that this guy is rational, and then you can bring in a physicist who understands how these balls behave. And the physicist could calculate the optimal shot, and then that would be your best prediction.
And Friedman says that this doesn't look right superficially: we are trying to predict the behavior of this billiard player who knows no mathematics. The physicist is producing this big mathematical model to describe his behavior. But Friedman still says, 'well that is the right way because there is no better way.' He says you can't ask the billiard player to explain how he arrived at his shot because he is not articulate -- he just knows. And this was used to justify representing people as if they were solving complicated mathematical problems. It's really ridiculous, actually, when you get down to it.
And your book is explaining why that story is unsatisfactory.
Realizing that we're not all skilled billiard players is the first step.
Sure -- maybe even the skilled billiard player has an inefficient sense of fairness, or has been told inaccurate stories about what optimal billiard playing looks like.