The Wilson Quarterly

Behavioral economics is the hottest thing in the dismal science. A parade of books and magazine articles in the last few years has informed us of its implications for business, politics, and public policy. The free-market ortho­doxy that took hold in the West with Ronald Reagan and Margaret Thatcher has been tried and found wanting, or so the thinking goes. It’s time to bury homo economicus, invisible hands and all, in a shallow Scottish grave next to Adam Smith, and to restore government to its rightful role in managing economic ­affairs.

Arguments about the de­merits of free enterprise and the merits of government intervention in the market­place are hardly novel. So what new wrinkle explains the re­cent flood of writing on the subject? Modern science, of ­course.

Behavioral economics looks at the role that emotion, social dynamics, psychology, and other factors can play in individual ­decision-­making. Modern social and laboratory science is illumin­ating with clinical clarity the ways in which individuals do not behave like rational economic actors. Humans have biases—for example, we tend to interpret new infor­mation in a manner that confirms our preconceived notions—that are difficult to overcome, and we are prone to enthusiasms, panics, and a host of emotions that cloud our judgment. Economists in the past didn’t deny that, but they had no way of gauging it or factoring it into their models—­and frequently had no desire to do ­so.

Animal Spirits, which attempts to leverage the insights of behavioral economics to reanimate the vision of John Maynard Keynes, is perfectly timed for the present moment.

George Akerlof and Robert Shiller, acclaimed economists at the University of California, Berkeley, and Yale University, respectively, have made their careers studying how and why individuals make all sorts of foolhardy economic decisions. Akerlof, who won the Nobel Prize in Economics in 2001, is famous for his 1970 paper “The Market for ‘Lemons,’” which explained how markets such as those for used cars malfunction because buyers and sellers possess differing degrees of information about the product (“asymmetric infor­mation” in econo-speak). Shiller is best known for an earlier book, Irrational Exuberance (2000), on speculative asset bubbles, as well as for a widely followed housing price ­index that bears his name and that of fellow economist Karl Case.

In Animal Spirits, the authors leverage the insights of behavioral economics to reanimate the vision of John Maynard Keynes (1883–1946), the most influential economist of the 20th century. He introduced several key concepts, such as aggregate demand, that illuminate how economies function and that are still used today. Keynes famously argued in favor of deficit spending during economic slumps as a way to ensure full employment, advice that clashed with the common assumption that governments should maintain balanced budgets, and is still the subject of debate ­today.

To be sure, Keynes acknowledged that most economic activity is the result of rational econ­omic calculations. But, the authors write, he also argued that “much economic activity is governed by animal spirits. People have non­eco­nomic motives. And they are not always rational in the pursuit of their economic interests. In Keynes’s view these animal spirits are the main cause for why the economy fluctuates as it does. They are also the main cause of involuntary unemploy­ment.”

The authors are taking some liberties here. Keynes referred to “animal spirits” when describing entrepreneurs who take great risk under conditions of extreme uncertainty. Animal spirits explain how entrepreneurs can innovate even when conventional economic analysis suggests that their gambles are unwise. This entrepre­neurial impulse yields new businesses, technologies, and innovations that can put people out of a job (as, for example, when ­carriage makers started producing automobiles and buggy-­whip manufacturers went out of business).

Animal spirits were never all that central to Keynes’s theories, however. Indeed, entrepre­neurs motivated by animal spirits were far more important to the economic vision of Keynes’s contemporary Joseph Schumpeter, who gave us the idea of “creative destruction,” and to subse­quent theorists of economic growth. That said, Akerlof and Shiller’s desire to resurrect and elevate “animal spirits” to improve our understanding of economic change is most welcome. But the implications of this idea sometimes appear to escape ­them.

The book is perfectly timed for the present moment. Keynes biographer Robert Skidelsky recently trumpeted the economist’s return to favor in the pages of the British journal Prospect. Economists across the spectrum, from the con­ser­vative Gregory Mankiw to the liberal Paul Krugman, have heralded Keynes’s insights in making sense of the current economic mess. Last year in The New York Times, Mankiw wrote that Keynes’s “diagnosis of recessions and depressions remains the foundation of modern macroecon­omics,” and Krugman observed that Keynes showed that “there were situations in which monetary policy could do no more,” and as a result that fiscal measures of the kind Keynes ­advocated—­deficit spending, for ­example—­were relevant ­now.

As we embrace modern behavioral economics, Shiller and Akerlof believe we are prepared to see how correct Keynes ­was—­he was a man of im­mense imaginative power and intuition and was far ahead of the scientific knowledge of the day. “With the advantage of over 70 years of research in the social sciences, we can develop the role of animal spirits in macroeconomics in a way that the early Keynesians could not,” they write.

So what’s the upshot? Government should act like a good parent, the proper role of which is to “set the limits so that the child does not overindulge her animal spirits” while allowing her the “independence to learn and to be creative.” Two other highly regarded academics with a keen interest in behavioral economics, Cass Sunstein, a University of Chicago law professor now working for the Obama admin­istration, and Richard Thaler, a professor of behavioral science and economics, also at the University of Chicago, take this view as well in Nudge: Improving Decisions About Health, Wealth, and Happiness (2008). In their estimation, government should act as a kind of ­nudger ­in ­chief. Do you want people to save more for their retirement? Make them opt out of their employer’s 401(k) plan if they don’t want to participate, rather than require all who want to establish one to opt in. The result: a vast increase in the number of people with 401(k)s. Shiller and Akerlof shy away from making many specific policy proposals. They point to the ways in which animal spirits shape phenomena such as unemployment and real estate markets, but leave it to economists and policymakers to devise new ­approaches.

All of this is a far cry from Ronald Reagan’s assertion that “in this present crisis, government is not the solution to our problem; government is the problem.” Indeed, the federal government now owns an insurance firm and has a significant stake in a number of banks, not to mention General Motors. President Barack Obama has called for a new era of oversight, remarking earlier this year that “we can no longer sustain ­21st-­century markets with ­20th-­century regulations.”

Yet there is still a reason to be doubtful that the government ­limit-­setting advocated by Shiller, Akerlof, and others will yield the beneficial outcomes they foresee. To understand why, it’s helpful to look at the book’s most striking anecdote, which concerns Andrew Cuomo. As the attorney general of New York, Cuomo has been busily attacking Wall Street bankers and insurers for their role in the financial crisis. Most of Animal Spirits was written before he decided to take on this new policing ­role.

In a chapter on real estate markets, the authors point out all the factors that helped to create the recent bubble. Given the past performance of real estate assets, “there is no rational reason to expect real estate to be a generally good investment.” But people believe real estate values will always rise, and institutions such as the Department of Housing and Urban Develop­ment (HUD) and the ­government-­sponsored enterprises Fannie Mae and Freddie Mac strongly shaped the housing ­market—­and its ­illusions.

Allegations that minority groups were being left out of this nascent boom “led to an almost immediate, and uncritical, government reaction.” As HUD secretary in the 1990s, the authors write, Cuomo “aggressively” increased the mandated lending by Fannie Mae and Freddie Mac “to underserved communities,” even if that meant lowering credit standards and loosening the require­ments for documentation from borrow­ers. As a political appointee, he was concerned not with future financial risks but with economic justice for minorities. So the government heed­lessly helped further inflate the housing ­bubble.

And this is the rub. The authors seem oblivious to the limits their own analysis ascribes to the ability of government to alleviate problems. Behavioral economists are right that individuals in the marketplace don’t always act rationally. But these same forces are at work in the minds and hearts of policymakers, regulators, and ­legislators—­folks like Andrew Cuomo. They may be ­well ­meaning, but they are prey to a kind of animal spirits, too. They may be blinkered in a quest for justice or fairness, or their own political ad­vance­ment. Biases may distort their percep­tions of the relative risks and rewards of regulations and ­policies.

Another school of economics, called public choice theory, tries to unpack the implications of this dynamic for public policy. The thrust of this approach is that we should (at a minimum) harbor skepticism that wise bureaucrats can decide an individual’s own best interest better than the individual can. The public choice school has produced its own eminent Nobelists, such as James M. Buchanan Jr. But in this book, Shiller and Akerlof do not wrestle seriously with it or with the challenge it poses to their hopes for a renaissance of Keynesian, technocratic policy.

* * *

Nick Schulz, is DeWitt Wallace Fellow at the American Enterprise Instittue and editor of The American. He is coauthor of the forthcoming book From Poverty to Prosperity: Intangible Assets, Hidden Liabilities, and the Lasting Triumph Over Scarcity.

Reviewed: Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George A. Akerlof and Robert J. Shiller, Princeton University Press, 230 pp, 2010.

Photo courtesy of Flickr/futureatlas

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