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04/16/2010

Book Review: Animal Spirits


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Animal SpiritsIn classic theory, homo economicus is a rational being who seeks to obtain the highest possible order for himself, who optimizes information, opportunities, and constraints. But George Akerlof and Robert Shiller, the authors of Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism (Princeton University Press, 2009), believe no such creature exists. Rationality, they say, limits the dimensions of inquiry, and isn’t the only tool we have. They argue that noneconomic methods are needed to reveal how real estate and the stock market can come to describe roller coaster drops and loop-the-loops, and, for example, how index averages could be halved in little more than a year. 

In John Maynard Keynes’s 1936 work, The General Theory of Employment Interest and Money, the phrase “animal spirits” refers to voids in quantitative economics that rational methodology does not explain. Now Akerlof and Shiller expand the term with reference to several other theories. Thomas Gresham’s insight that “bad money drives out good money” is crucial to this book, but the authors build on their own previous work as well, particularly Akerlof’s 1970 paper “The Market for Lemons: Quality Uncertainty and the Market Mechanism” (one of the most cited papers in economic theory, which helped him win a 2001 Nobel Prize in company with Joseph Stiglitz and Michael Spence), and Shiller’s various challenges to the efficient market model, issued most famously in his Irrational Exuberance (Princeton UP 2000), a New York Times best seller. 

Animal Spirits identifies five elements that are key drivers of the economy and markets and that are essential to diagnosing problems and prescribing solutions: confidence, fairness, corruption, money illusion, and exaggeration. Of these, the authors’ discussion of the role played by confidence in breaking the financial side of serialization is particularly engrossing.

When people are confident, they buy, of course. And when they lack confidence, they sell. Confidence, say Akerlof and Shiller, has a multiplier effect on national income, like the Keynesian multipler effect, which is defined as “1 divided by (1 minus the marginal propensity to consume).” They believe that the failure of conventional economic theories to take account of lost trust and confidence, to provide for the role of corruption, and, in general, “to consider the most important dynamics underlying economic crises” goes a long way toward explaining how most investors failed to foresee the credit crisis.

Ideologists are likely to dismiss this volume. However, for other readers—whether their perspectives are quantitative or qualitative—Animal Spirits may fill a troubling gap in existing investigations of the causes of booms and busts.

–Thomas H. Wilkins, CFA, is chief executive manager of Joseph Jekyll Advisors, LLC.

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