Economics is no different from the ramps of Paris when it comes to fashion. Like their Parisian analogues, economic ideas are subjects of whim, fancy, boredom and fatigue. So the re-questioning of economic orthodoxy that began in the wake of the US recession in December 2007 seems to be just another passing fad. It appeared to be the re-emergence of Keynesian thinking that had been consigned to history in the wake of the stagflation of the 1970s.
Hardly. As George Akerlof and Robert Shiller show in a new book, Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism (Princeton University Press, 2009), this is no freak storm. It may mark the long-awaited encounter between psychology and economics.
At their base, many economic constructs (utility functions, for example), microeconomic theories (choices and preferences of consumers) and even macroeconomic ideas (Keynes’ “animal spirits”) are grounded in psychology. Economists, however, are loth to admit that. This base has now been covered with layers of empirical observations, derived theories and dense mathematics that somehow suggest that economic concepts exist on their own, without any psychological roots. In any case, psychology is banished soon after one finishes elementary microeconomics.
The tale of that cleansing is long; a one-paragraph version of it runs something like this: Humans can carry out complex calculations and when given complete information about prices, the probability of occurrence of various events of economic importance, can optimize in any situation to their advantage. The assumption here is that humans are “rational”, a term defined in a manner that excludes any other behaviour but self-interest. In this view, emotions, attachments, pain and happiness have no bearing while we go about making everyday economic decisions.
One version of such theorizing is the Expected Utility Theory (EUT). Expected utility is the compound of probabilities of occurrence of different events (for example, winning a lottery, the possibility of succeeding in a job interview, and the like) and the utility function of an individual. Consumers and entrepreneurs make choices that maximize their expected utility. For example, given a choice between getting $1 million and $1,000, one would choose the $1 million. But one would be indifferent between choosing $1 million with 10% probability and $100,000 with certainty. This is not true. Experiments have shown that choices made depend on the amounts that are on offer. In fact, there are a host of other factors (such as the age of those making the choices and cultural settings among others) that interfere when we compute the alternatives.
Experimental economics has shown that there are serious divergences from what EUT states and how humans behave in reality. Emotions such as fairness, anger, retribution and a host of others enter in economic decision making in a vital manner. These results, important as they are, have remained confined to laboratory settings and academic writing.
Akerlof and Shiller’s book is probably the first macroeconomic exploration of the subject that is accessible to those interested in the subject but who don’t have the academic training to understand the detailed arguments. The authors base their explanatory scheme on Keynes’ now famous “animal spirits”. Akerlof and Shiller argue that animal spirits are a blend of five elements: confidence, fairness, corruption and anti-social behaviour, money illusion and stories. Using these elements, they explore eight questions of current interest. All of them are linked in one way or another to the unfolding economic and financial crisis.
Any serious economist would eschew explanations based on something as vague as confidence. But is confidence really a vague economic notion? In “normal” circumstances one would base one’s choices only on the basis of prices, expected returns, the time horizon of investment and other technical parameters. But suppose you were to encounter an ace investor who has a record of fetching neat returns on your money, you would be “confident”. In that sense, confidence is a departure from the normal, rational, computation of alternatives. Thus it belongs, properly, to the category of animal spirits.
The authors say, “But there is more to the notion of confidence. The very meaning of trust is that we go beyond the rational. Indeed the truly trusting person often discards or discounts certain information. She may not even process the information that is available to her rationally; even if she has processed it rationally, she may still not act on it rationally. She acts according to what she trusts to be true.” (P12).
There is strong evidence that all booms begin with a departure from rational calculations. Akerlof and Shiller analyse the US recession of the 1890s and the Great Depression to show that excessive confidence stood behind the follies of those times.
What about the present crisis? Every crisis appears unique as it unfolds. There is no doubt the sub-prime crisis involved financial complexity of a kind never seen before, but it had at its root the psychological factors that propel markets in the wrong direction. As in any other crisis, extremes of confidence are at the core of the problem.
So far there has been little effort at modelling confidence.
Akerlof and Shiller’s book tries to make use of intuitive understanding of these relatively unexplored (from an economics perspective) psychological categories in explaining macroeconomic phenomena. That is, at once, a strength and weakness of their framework, if it can be termed as weakness. In terms of explaining “everyday” economics, they have done a splendid job. But in formal, disciplinary terms, they’ve jumped the gun. That, however, is not a shortcoming, given the audience they may have in mind.
Siddharth Singh is deputy editor, Views, at Mint. Comments are welcome at firstname.lastname@example.org