Animal Spirits

The new book from George Akerlof and Robert Shiller, Animal Spirits, has been getting a lot of press of late, and quite rightly: it's really good. It's not only very readable; it also offers a compelling vision of a very different type of macroeconomics -- one where behavioral considerations are front and center, rather than simply providing what Clive Crook calls "ad hoc modifications" to the standard, ridiculously oversimplified and unrealistic, model.

Conor Clark has an interview with Akerlof today, in which Akerlof thinks about moving away from the idea of countercyclical fiscal and monetary policy, and moving towards a more broader notion:

One of the roles of the government is to offset the animal spirits. So that when animal spirits are high -- and people are too trusting and they engage in investment projects that they shouldn't engage in -- one of the roles of the government is to offset them. More should have been done to curb the over-exuberance and excesses in the housing market. That's one.
But at the same time, if the confidence then dries up, it's the role of the government to stimulate the demand that's fallen because of the lost confidence.

This is much bigger than the idea that it's the job of central bankers to identify bubbles and gently deflate them before they get too big. For one thing, it draws no clear distinction between fiscal policy and monetary policy; instead, it looks at the animal spirits of the country as a whole, and tries to keep them on a relatively even keel. That has very little to do with targeting inflation, and is only partly concerned with targeting full employment: it's a distinct notion, made up of different parts, and one which this book goes a long way to addressing in a rigorous manner.

David Merkel has a great post on how this kind of thinking can reveal problems with investment strategies, or the lack thereof:

Because people don't like to think hard, they don't optimize, as the neoclassical economists posit. Instead, they choose solutions that they deem to be "pretty good," and stop their searching. Searching is a cost. But neoclassical economists insist that consumers maximize utility and producers maximize profit anyway. Why?

On an individual level, it's really important to examine one's own biases as pitilessly as possible; on a national level, I see the job of entities such as Paul Volcker's Economic Recovery Advisory Board to be one of gauging the level of animal spirits across the country -- something that all central bankers do by nature, which is one reason that Volcker is a good choice to head it.

I should also mention that if you're into all this stuff, and you're looking to read up on more of it, don't necessarily stop at Nudge. There's also Free Market Madness, by Peter Ubel, which fits nicely in between the policy-oriented empirical micro-experiments of Thaler and Sunstein, on the one hand, and the big-picture architecture of Akerlof and Shiller, on the other. Also, Ubel is a physician, which makes his book a refreshing change from those of the economists. But if you only read one book on this subject, make it Animal Spirits.