The latest issue of The Economist has a review of Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by two global heavyweights in economics—George Akerlof and Robert Shiller. The authors talk of five other “spirits” that they derive from Keynes’ reference to animal spirits. They are confidence, fairness, corruption (or bad faith), money illusion and “stories”. The authors, we read in the review, opine that on many occasions, these spirits play an important role in influencing our responses rather than just the rationality assumed by economic models.
The subject I propose to tackle today is humility which is related to confidence (overconfidence)—one of the moving spirits of economics, according to authors. There is no evidence yet that humility has arrived, despite the mayhem. Hence, I find it difficult to believe that we have solved or brought the crisis under control.
The Financial Times can take credit for giving a new word to the English language. On 20 March, this is how its news item on a slew of Ponzi schemes that regulators in the US have unearthed began: “US federal regulators have warned of a ‘rampant Ponzimonium’ as they disclosed they are investigating ‘hundreds’ of possible scams in the aftermath of the $50 billion fraud allegedly perpetrated by Bernard Madoff.
“Bart Chilton, a commissioner at the Commodities Futures Trading Commission, the US regulator, said the watchdog was ‘seeing more of these scams than ever before’ in commodities and other futures markets.”
At the core, the common thread between light-touch regulators, “diffused risk” policymakers and Ponzi-schemers is the belief that the business cycle had been tamed. They all began to believe that the sky would always be blue and that it would not be a limit either. The belief that they had tamed business cycles through their astute policy moves over the last two decades and that rising asset prices were a vindication of their approach to economic policymaking had grown firm roots. The success claimed in taming consumer price inflation illustrates this vividly.
The argument went thus: Inflation had been held down because central banks had become independent of political influence. Such independent central banks had dampened business cycle volatility and held inflation within a tight band. They did not adequately account for the fact that inflation had come down due to a combination of several factors and that the declining trend in inflation could and would reverse itself once these trends waned or weakened. They were the shift of manufacturing to low-cost centres, the declining power of labour unions in the West and a prolonged slump in commodity prices.
As the Indian, Chinese and other developing economies began to grow faster, their cost advantage began to erode. Commodity prices were no longer falling either. Only the power of labour unions is yet to be restored to its former glory. Hence, when the inflation spike happened in 2007-08, central banks were slow to react and stuck to the lame defence that core inflation was contained.
In other words, the belief that they had done all the right things and continued to do so blinded them to the possibility that a combination of special factors had shaped their success. If they had not been thus blinded, they would have been more open-minded about their limitations and approached the problems differently.
The same thought process drove the attitude of other players, down to the borrowing public. Everyone began to accept that rising asset prices were their fundamental right. Nothing could stop it. Even if something temporarily did, that would be fixed by policymakers. This permeated developing economies too. The public and governments there too began to think that higher growth rates were now their entitlement and nothing would come in the way of their claim to it. Bare Talk reckons that this is the unifying explanation to the global nature of the problem. Bad ideas diffuse faster and that is a universal law of our times.
Undoubtedly, policymakers, academics and leading economists who always spoke of “soft landing” must bear a large share of the blame for the current situation. Their confidence infected the public in their countries while their reach message was carried by their imitators in the developing world.
Just consider this attitude: Rising asset prices reflect fundamentals while falling and lower asset prices are a liquidity problem. That explains everything. If asset prices go up, it is because of good fundamentals (that I played a role in creating) but if they decline, then it must be because of irrational withdrawal of liquidity that greases market wheels. It will be hard to find a better example of hubris.
Of course, many economists and bankers would yawn at this explanation. That is the problem. We must remember the modeller’s manifesto of Emanuel Derman and Paul Wilmott: The world does not satisfy our equations. Unfortunately, if Chrystia Freeland is right, we are on course to discovering the truth too late to stop it.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org