Book review: Animal Spirits by Akerlof and Shiller

[From Monday's FT]

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism
By George Akerlof and Robert Shiller
Princeton University Press, $24.95

This is a good moment to propose a re-examination of orthodox economics. The current breakdown, possibly the worst since the Great Depression, was a shock to all but a handful of economists. It calls into question much of what they thought they knew.

Why did things go so wrong? What should governments do now? How do we stop it happening again? In their new book, two of the most creative and respected economic thinkers currently at work, George Akerlof and Robert Shiller, argue that the key is to recover Keynes's insight about "animal spirits" - the attitudes and ideas that guide economic action. The orthodoxy needs to be rebuilt, and bringing these psychological factors into the core of economics is the way to do it.

Topicality can be a mixed blessing. The book was mostly written before the crisis became acute. A little awkwardly, the authors have tacked an excellent postscript, about what needs to be done, on a chapter about monetary policy. The connections between their thinking on the limits to conventional economics and the issues thrown up by the breakdown are plain, even if they were unable to make every link explicit. Even more than Akerlof and Shiller could have hoped, therefore, it is a fine book at exactly the right time.

Though it calls for a reworking of economic theory, Animal Spirits is not a difficult book. It is short, chatty and anecdotal. The general reader will be engaged and drawn in. But the book is serious, too. Good notes and a bibliography are a guide to the literature that the book aims to tie together. Animal Spirits carries its ambition lightly - but is ambitious nonetheless. Economists will see it as a kind of manifesto.

The first quarter divides animal spirits into five categories. They are confidence, whose role is pervasive and which stars throughout the rest of the narrative; fairness, which influences wage-setting and the working of the labour market; corruption and bad faith, which can especially affect financial markets; money illusion, the propensity to be fooled by inflation; and "stories", which they could have called "culture", a catch-all for economically significant ideas about the world and one's place in it.

The rest of the book shows how thinking about these animal spirits yields answers to big questions that perplex orthodox economics - or force it to make bizarre and implausible assumptions. Why do economies fall into depression? Why is there unemployment? Why are financial prices so volatile? Why does the property market go through cycles? Why are minorities often especially poor? The answer in each case is partly, and sometimes mainly, animal spirits

Chapter by chapter, the analysis is fascinating and usually persuasive. Whether the larger project can be made to hang together, though, I doubt. The authors' criticisms of the standard model are well taken and not that controversial. The orthodoxy assumes rational optimising behaviour, and is reluctant to contemplate more than minor deviations from that principle; as a result, it often goes astray. Ad hoc modifications, such as those the authors suggest, may get better results.

Without saying how, the book aspires to go further and calls for a new standard model. That is hard to envisage. The assumption of rational optimisation is a gross simplification, no doubt, but despite all the drawbacks emphasised in the book, it has been a highly productive one. Shiller and Akerlof would be the last to deny the power of the insights it has yielded. At issue is whether a psychologically enriched standard model would be too complex to offer useful simplifications. The standard model plus ad hoc modifications suited to the particular case might be the best economics can do.

A different problem arises in moving from explanation to prescription. Akerlof and Shiller argue convincingly that animal spirits give a richer and truer account of economic fluctuations. How to manipulate them for policy purposes, and when it might be right to try, are separate questions. The authors are doubtless sympathetic to the case for "libertarian paternalism" in Nudge, by Richard Thaler and Cass Sunstein - another valuable book that explores the possibilities of "behavioural economics". What the two have in common is the idea that once you take account of animal spirits, people can be guided, without being forced, to do what is in their best interests.

The question is, what about the claims of liberty? Likening the role of government to a parent's duty to create a happy home, the authors write: "The proper role of the parent is to set the limits so that the child does not overindulge her animal spirits." This is an unappealing analogy. I would sooner take up arms against a government that saw me as a child than vote for it.