Various governments have attempted to use lower interest rates to reinvigorate the slack business cycle following the mid-September collapse of Lehman Brothers Holdings Inc. Their relative lack of success at fixing the economic crisis, particularly the slowness with which monetary policy has flowed through the system, has played a role in bringing behavioural economics to the fore. As monetary policy has failed to pick up, leaders of the Group of Twenty (G-20) have ponied up a giant fiscal stimulus running to at least $1 trillion. It is still too early to conclude whether this stimulus will work.
An explanation for why such stimuli do not always work has forced economists to delve into the recesses of human behaviour theory. Most commonly, economists have referred to John Maynard Keynes, who in his writings recognized that one of the reasons for fiscal stimuli to work was simply that increased spending by a government is really a “freebie”, and there is nothing quite like a freebie to inspire entrepreneurs to economic action.
Keynes pointed out that much economic activity is not a result of cold-blooded cost-benefit analysis, but a belief that action is better than passivity, a principle he quaintly described as the “animal spirits” of the economy. In today’s context, there is a greater desire to understand what Keynes meant by “animal spirits” and how these can be exploited to achieve more effective economic outcomes.
This attempt to bring human behaviour theory to the forefront of the economic debate has been reinforced by the publication of Animal Spirits, the new book by George Akerlof and Robert Shiller. Akerlof is a giant among economists, a Nobel laureate, whose work on the working of markets under insufficient information has influenced the field profoundly.
Robert Shiller of Yale has been known for his prescient views about market collapses and his predictions have been proven right more than once. That two of the foremost names in the profession have come together to recognize the impact of human behaviour on real economy charts a new path for the subject.
Akerlof and Shiller say in their book that “animal spirits”, which drive economic behaviour, manifest themselves in many ways. Most important in their estimation is “confidence”, which induces persons to invest freely (unreasonably) when markets rise and to curtail expenditure, perhaps irrationally, during downturns. This element is missing today and continues to delay economic recovery. In addition to confidence, the authors list four more animal spirits—fairness, corruption, money illusion, and stories—which explain different drives of economic action. Most of the economic issues faced in the past few years are caused by a combination of the above animal spirits.
The authors explain a few of the causes of the current crisis through their thesis. They believe that the crisis had its origin in the faith that housing prices could never go down. This erroneous belief is seen to be a result of false confidence that the market would sustain, and a “money illusion”, wherein the true value of houses was low even though their nominal value may have appeared to be high. In a similar vein, the authors recognize that confidence alone would not have caused indiscriminate home ownership. It also required banks to be prepared to lend mindlessly to potential home owners. This was possible due to an element of “corruption” in the consciously careless manner in which home loans were given.
There was also a “story” known to be false, but still perpetuated by various politicians, that less privileged Americans were being priced out of the mortgage market.
This story then led to a justification for wanton politically motivated lending. Stories about the pricing out of less privileged groups became so pervasive that it became politically incorrect for credit and risk officers to question the now infamous “Ninja” (No income, no job, no assets) loans. Most famous among the “stories” was the notion of the infinite capacity of asset bubbles to grow, amplified by a central bank chairperson who was elevated to rock star status.
The book also notes that while such “animal spirits” can push individuals to act in ways not supported by economic logic, equally, corrective actions will be taken only if there is belief in “fairness” in the system. Unless individuals feel that the actions of others can be relied on, they will not act at all in response to institutions such as central banks, government and the fair working of markets. There was, once, considerable “trust” that the borrow short-term and lend long-term practices of the major non-banks was a sustainable model. Now that this bond among banks and between the consumer and government regulators has been broken, rebooting the market is proving difficult.
One hopes that with renewed focus on the behavioural drivers of human action from two leading economists, these elements will come into the mainstream of the subject. Governments and boards of companies will need to be sensitized to the “animal spirits” that bear watching. They will need to consider when the “stories” of today cross the line into “corruption” and drive unacceptable behaviour. They may want to ask if the risk reward structure in different situations appear “fair”, or if there are distorted incentives present. For instance, was “fairness” served recently by the willingness to fund at least Rs18,000 crore to resuscitate the real estate sector, while at the same time not lending enough elsewhere? The “fairness” as well as the “stories” of firms and bankers who fanned the very high equity valuations of 2007, are now called into question and regulators need to assess what can be done to restore “trust” for the markets to revive. Finally, and most critically, companies and regulators will need to keep asking whether the level of confidence in an industry has caused an untenable asset bubble or not.
Naturally, there can be no clear answers to these questions. Thus far, the economic debate has focused on interest rates, employment levels, gross domestic product growth, etc., and these measures alone have proved inadequate to meet the current challenges. Economic analysts will now need to include an assessment of human factors in their studies.
This book shows that several classes of economic problems cannot be addressed without questioning their underlying “animal spirits”. Akerlof and Shiller, by reinforcing the importance of behavioural causes in creating and solving problems, have now shown us how important it is to ask these questions about “animal spirits”, however fuzzy the answers may be.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He will write on issues related to governance. The views expressed in this column are personal. Write to him at firstname.lastname@example.org