Animal Spirits Among Us

Georg A. Akerlof
Robert J. Shiller

(adapted from Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism (Princeton University Press, 2009); by permis- sion of Princeton University Press) 

To understand how economies work and how we can manage them and prosper, we must pay attention to the thought patterns that animate people’s ideas and feelings, their animal spirits.We will never really understand important economic events unless we confront the fact that their causes are largely mental in nature. 

It is unfortunate that most economists and business writers apparently do not seem to appreciate this and thus often fall back on the most tortured and artificial interpretations of economic events. They assume that variations in individual feelings, impressions, and passions do not matter in the aggregate and that economic events are driven by inscrutable technical factors or erratic government action. In fact, the origins of these events are quite familiar and are found in our own everyday thinking, our animal spirits.*

Flawed Theory

The real problem is the conventional wisdom that underlies so much of current economic theory. So many members of the macroeconomics and finance profession have gone so far in the direction of “rational expectations” and “efficient markets” that they fail to consider the most important dynamics underlying economic crises. Failing to incorporate animal spirits into the model can blind us to the real sources of trouble.

The crisis was not foreseen, and is still not fully understood by the public, and also by many key decision makers, because there have been no principles in conventional economic theories regarding animals spirits. Conventional economic theories exclude the changing thought patterns and modes of doing business that bring on a crisis. They even exclude the loss of trust and confidence. They exclude 

We are currently not really in a crisis for capitalism. We must merely recognize that capitalism must live within certain rules. 

he role of corruption and the sale of bad products in booms, and the role of their revelation when the bubbles burst. They also exclude the role of stories that interpret the economy. All of these exclusions from conventional explanations of how the economy behaves were responsible for the suspension of disbelief that led up to the current crisis. 

It is necessary to incorporate animal spirits into macroeconomic theory in order to know how the economy really works. In this respect the macroeconomics of the past thirty years has gone in the wrong direction. In their attempts to clean up macroeconomics and make it more scientific, the standard macroeconomists have imposed research structure and discipline by focusing on how the economy would behave if people had only economic motives and if they were also fully rational.

To our minds, this model is severely lacking. It fails to explain the euphoria followed by pessimism.

Capitalism Then and Now

But this view of economics is surprisingly popular, not just among professional economists and policy makers but also among the general public. In this view capitalism has brought to consumers in developed economies vast riches undreamed of in previous centuries. The average North American, European, or Japanese consumer has a higher standard of living than a medieval king. She eats better; she lives in housing that is much less roomy but much more comfortably heated; her television and radio, at the press of a button, give her better and more varied entertainment; the list goes on. In addition, as we write, other countries – Brazil, China, India, Russia – are rapidly climbing the GDP ladder.

We agree regarding the wonders of capitalism. But that does not mean that there are not different forms of capitalism, with very different properties and benefits. The debate about which form of capitalism we should have goes far back in American history and is notable for its many sharp reversals. At the beginning of the nineteenth century there was fierce debate over the role of government in the American economy. The Democrats were opposed to government intervention, while the Whigs thought that the government should provide the backdrop for a healthy capitalism. For the federal government this would mean initiation of a system of national roads. Andrew Jackson and later Martin van Buren were against the plan. In contrast, John Quincy Adams and Henry Clay were in favor of it.

And this debate has gone back and forth several times since then. The last major shift occurred in the 1970s with the election of Margaret Thatcher in the United Kingdom and in the 1980s with the election of Ronald Reagan in the United States. For the previous thirty years, with the general acceptance of the New Deal, the dominant thinking of policy makers had been that government was to play a key role in providing the infrastructure for a capitalist society. This infrastructure consisted of not just physical

highways, an educational system, and support of scientific research, but also regulations, especially those governing financial markets. At the end of the 1980s we had an economic system that was remarkably well adapted to weather any storm. For example, the S&Ls failed massively, but the system of government protections contained the macroeconomic damage. The failure cost taxpayers quite a bit of money, but only in rare instances did it cost them their jobs.

But then – and this is another part of our story – the economy, as it always does, changed. It adapted to the regulations that were in place. With the general acceptance after the 1980s of the belief that capitalism was a free-for-all, the playing field may have changed, but the rules of the game were not 

We had forgotten the hard-earned lesson of the 1930s: that capitalism can give us the best of all possible worlds, but it does so only on a playing field where the government sets the rules and acts as a referee. 

adapted. This has been nowhere more apparent than in the financial markets. The housing market illustrates this perfectly. In the old days, there were natural limits on home mortgages. The commercial banks and savings banks had reason to be careful in their initiation of a mortgage. They themselves would be its most likely holder. But then all that changed. The banks became the initiators, but not the holders, of mortgages. But regulation did not adapt to reflect this change in the financial structure.

Rules of Engagement

Public antipathy toward regulation supplied the underlying reason for this failure. The U.S. was deep into a new view of capitalism. We believed in a no-holds-barred interpretation of the game. We had forgotten the hard-earned lesson of the 1930s: that capitalism can give us the best of all possible worlds, but it does so only on a playing field where the government sets the rules and acts as a referee.

Yet we are currently not really in a crisis for capitalism. We must merely recognize that capitalism must live within certain rules. Indeed our whole view of the economy, with all of those animal spirits, indicates why the government must set those rules. It may be true that in the classical model there is full employment. But in our view the waves of optimism and pessimism cause large-scale changes in aggregate demand. When demand goes down, unemployment rises. It is the role of the government to mute those changes.

In our view capitalism does not just sell people what they really want; it also sells them what they think they want. Especially in financial markets, this leads to excesses, and to bankruptcies that cause failure in the economy more generally. All of these processes are driven by stories. The stories that people tell to themselves, about themselves, about how others behave, or even about how the economy as a whole behaves all influence what they do. These stories are not stable but vary over time.

Such a world of animal spirits gives the government an opportunity to step in. Its role is to set 

We are writing at a time when people seem to be rethinking their views of the economy. Now people are seeking new answers, urgently. 

the conditions in which our animal spirits can be harnessed creatively to serve the greater good. Government must set the rules of the game.

If we thought that people were totally rational, and that they acted almost entirely out of economic motives, we too would believe that government should play little role in the regulation of financial markets, and perhaps even in determining the level of aggregate demand. But on the contrary, all of those animal spirits tend to drive the economy sometimes one way and sometimes another. Without intervention by the government the economy will suffer massive swings in employment. And financial markets will, from time to time, fall into chaos.

We are writing at a time when people seem to be rethinking their views of the economy. The recent economic turmoil has brought back to the table many questions that had been considered settled. Now people are seeking new answers, urgently. We see it in the newspapers. We see it in the think tanks, and at conferences, and in the corridors of our eco- nomics departments.

Invisible Hand, Visible History

From time to time it appears that democracies undergo great shifts in their stories of who people are and who they should be. Associated with these shifts are changes in the stories about how the economy works. We might view the U.S. as having undergone six such major shifts: at the time of the Revolution, after the elections of Andrew Jackson and later of Abraham Lincoln, at the end of Reconstruction, during the Great Depression, and after the election of Ronald Reagan. Historians may disagree with us on the details of these changes of story, but since much of history is about such shifts, they are unlikely to argue with us about their existence.

Nor are they likely to disagree with us about the most recent such shift, coinciding with the election of Ronald Reagan. At that time the explanation of how the economy worked turned to the conservative image of the “invisible hand.” The story of the invisible hand and its consequences gives surprisingly detailed prescriptions regarding the role of government, even pertaining to questions of great specificity. But now people are asking these questions anew. Here is a small sampling: how can we allow people of varying abilities and financial sophistication to express their preferences for investments without making them vulnerable to salespeople selling “snake oil”? How can we allow people to take account of their deep intuition about investing opportunities without inviting speculative bubbles and bursts? How can we decide who should be “bailed out” and when? What regulation should there be for hedge funds? For investment banks? For bank holding companies?

It is our contention that the working of the economy, and the role of government in it, cannot be described solely by considering economic motives. Such description also requires detailed understandings of confidence, of fairness, of opportunities for corruption, of money illusion, and of stories that are handed to us by history. These are real motivations for real people. They are ubiquitous. The presumption of mainstream macroeconomics that they have no important role strikes us as absurd. The solutions to our economic problems can only be reached if we pay due respect in our thinking and in our policies to the animal spirits. 

George A. Akerlof is Koshland Professor of Economics at the University of California, Berkeley, and the 2001 Nobel Laure- ate in Economics. Robert J. Shiller is the Arthur M. Okun Professor of Economics at Yale University. 

* EDITOR’S NOTE: The authors describe animal spirits as human urges and impulses that help explain economic fluctuations. The authors take inspiration from economist John Maynard Keynes, who discusses animal spirits in his General Theory of Employment, Interest and Money (1936). Shiller and Akerlof identify five aspects of animal spirits that dramatically affect the economy: 1) confidence, with its cycles of optimism and pessimism and feedback mechanisms between it and the economy that amplify disturbances; 2) fairness as a motivating consideration in decisions such as setting wages and prices; 3) the role of corruption; 4) money illusion, people’s confusion over or neglect of the effects of inflation or deflation; and 5) stories, the narratives we tell about ourselves, those political or media stories that have power to explain events and move markets.