Human Psychology Influences the Recession

The cover of Animal Spirits, George Akerlof and Robert Shiller’s book arguing that human psychology plays a crucial part in the economy, conveys much of its message. Furry, droopy-lidded beasts cling to a no-nonsense black line meant to convey the stock market’s highs and lows. The animals fortunate enough to be perched on its peaks are grinning and flashing thumbs-up signs; the ones on the bottom are grim and frightened.

“This is the spirit of the book,” said Akerlof, a Nobel Prize laureate in economics and professor at UC Berkeley, to a large crowd at the Central Library.

Akerlof joined his co-author Shiller, a Yale economist and syndicated columnist, to explain why so-called animal spirits – Depression-era economist John Maynard Keynes’ term for the less-than-rational tendencies that drive our decisions – play a key role in booms and busts.

Homo economicus, extinct

Guests with George AkerlofThe reason very few economists saw the financial collapse of last fall coming, Akerlof said, was in part because most believed that private markets were self-policing, and that people acted knowledgeably and rationally. Even in diagnosing the problem after it happened, Shiller said, many economists pointed to purely technical causes, like banks’ “toxic assets” or the “pro-cyclical capital requirements” the market places on them. The core of economic theory for the last three decades, Shiller added, has developed around the assumption of rational actors and efficient markets.

“If everyone is rational, why did we get into this mess?” Shiller asked. “This is a fundamental conundrum.” Akerlof and Shiller posited that five “animal spirits” drive human decision-making and markets, sometimes in ways that contradict rationality.  These are confidence, fairness, corruption and bad faith, money illusions, and stories.

Confidence played a key role in the current crisis. People invested in complex financial instruments, or in houses, because of their confidence, or complete trust, in the market. Also key were corruption and bad faith. Akerlof noted that capitalism, however effective a generator of growth, produces anything that will make a profit, and takes advantage of overconfidence in markets.  “Unregulated capitalism may produce good medicines that may cure our ills,” he said, “But unregulated capitalism also produces snake oil that does not cure our ills. It may even find it profitable to produce the desire for the snake oil itself.”

Once upon a boom

Animal Spirits guestsThe key spirit may be the last – stories we tell ourselves about the economy and our decisions are key factors in booms and busts, Akerlof and Shiller argue. “People act and think and live according to stories,” Akerlof said. “In any given time, there’s usually a story about how the economy is behaving.” While truthful, he said, these stories tend to be over-exuberant or overly pessimistic. For the latest boom, the story was that “there’s a new alchemy out there,” Akerlof said. “Somehow Goldman Sachs or some other company had taken care of the risk problem for you.”

The reason for this storytelling is simple human nature, Shiller noted. The brain, he said, tends to organize around stories, and we are more likely to remember a story with a human-interest angle rather than mere collections of facts. During the dot-com boom, the economy rose on a wave of stories about how anyone could be a smart investor, and how old rules didn’t apply to new technology, he explained. And during the housing boom, we believed that because land is scarce, skyrocketing housing values made sense.

Animal Spirits guestsMemories or artifacts of such stories stick around, Shiller said, suggesting that their psychological effect on the economy can be long-lasting. The evidence, he said, is on jars of Hellman’s Mayonnaise. The label still reads “real mayonnaise,” presumably to distinguish it from the Depression-era fake stuff, Miracle Whip, even though now, few really know the difference. (Starbucks’ instant coffee, Shiller said to a laugh, may be our generation’s Miracle Whip.) “I’m just worried about the psychological scars that we’re introducing at this point,” he said.

The Jon Stewart-Jim Cramer face-off, explained

Stories are so typical to human understanding, Shiller noted, that one early 20th century literary theorist proclaimed that there are only 36 tales that have managed to compel us for all time. “I was looking down [his] list,” Shiller said to a laugh. “I can find the Jon Stewart-Jim Cramer story….‘innocent despoiled by those who would protect.’”

Animal Spirits guestsThat storyline means that many people are “really, really angry,” he said. One audience member seemed to prove the point when he asked, to some applause, “When is somebody going to get it?” That is, when will those who profited during or even from the crisis be punished? Akerlof and Shiller did not advocate a punitive response – especially one that breaks contracts – though it has been done in the past, Shiller noted. Franklin Roosevelt confiscated gold from consumers’ holdings and didn’t pay for it at the promised rate. But as Akerlof said, “The District Attorneys are gearing up.”

Building a better economy

In some ways, Shiller and Akerlof admitted during Q&A, human psychology will always play a part in the economy. “There’s a tendency for people to be willing to buy snake oil,” Akerlof said. The goal of economic regulation and reform, they said, should be to make it harder to buy and sell snake oil. Akerlof and Shiller suggest something like an “FDA in terms of financial markets.” They argue that there should be a fiscal target for full employment (and noted that the stimulus bill is taking too long), and a plan “to get credit back to normal.” Putting Fannie Mae and Freddie Mac under conservatorship was a good start toward this end, Shiller said. He also praised Barack Obama for touting home equity insurance, which Shiller has long advocated.

They anticipated that the country has five or 10 years of work ahead to “revamp our regulatory system, to revamp our consumer protections, to revamp our financial institutions.” As Akerlof noted during Q&A, during the 1930s the country did manage to fix banking institutions and set the path for 70-odd years without any major recessions. “We get this problem solved, and we should be back on track,” he said. “The ingenuity of millions of people thinking together and coming up with new ideas leads to cures that are really marvelous.”

Watch the video here.
See more photos here.
Buy the book here.

*Photos by Aaron Salcido.

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