Wednesday, June 24, 2009

Book Review: Animal Spirits by Shiller and Akerlof

"Some books are to be tasted; others swallowed; and some to be chewed and digested."
-Francis Bacon

Animal Spirits clearly falls under the “chewed and digested” category. Economics is in a state of crisis and there's been much debate about the myth of efficient markets and rational human beings. This book presents a framework to explain the nature of markets, and the importance of human psychology in it. Don’t be fooled by the thin appearance! Instead of a quick read, you’ll find pages which challenge conventional wisdom every step of the way.

The authors are famous economists. Mr. Akerlof won a Nobel Prize in 2001, while Robert Shiller first gained prominent recognition with his book “Irrational Exuberance”, which was published just before the stock market peak in 2000. The second edition, out in 2005, warned about the bursting of the housing bubble.

So what are animal spirits? Animal spirits are essentially thought patterns that animate people’s ideas and feelings. The book describes five different aspects of animal spirits and how they affect economic decisions – confidence, fairness, corruption, money illusion and stories. Confidence is procyclical, and is similar to the Keynes multiplier. When confidence is up, asset prices start rising. Fairness basically influences wages. The authors consider whether concerns about fairness and social expectations trump the consequences of strictly economic motivations. Money illusion refers to the fact that participants can’t seem to see through inflation. “Stories” is a term to describe ideas that become widely accepted in the society. For instance, the internet mania in the late 90s and the “house prices never go down” mantra were widely accepted “stories”.

The authors use their animal spirits theory to answer the following questions:

"Why do economies fall into depression? Why do central bankers have power over the economy? Why are there people who can’t find a job? Why is there a tradeoff between inflation and unemployment in the long run? Why is saving for the future so arbitrary? Why are financial prices and corporate investments so volatile? Why do real estate markets go through cycles? Why does poverty persist for generations amongst disadvantaged minorities? “

For instance, to explain why economies fall into depression, they show how the previous depressions in the US occurred due to fundamental changes in confidence in the economy, in the willingness to press pursuit of profit to antisocial limits, in money illusion, and in changes in the perception of economic fairness. Their discussion on the power of the central bankers is extremely relevant in today’s environment.

The book makes a compelling case that it might be time to redesign financial regulations to take account of the animal spirits that often drive markets, to make markets work more effectively, and to minimize bailout costs. The question of animal spirits is important, as “the future of any country is in the hands of the business people who decide on investments, and it is in large measure dependent on their psychology."

Some of the unresolved questions which the authors ask in conclusion are actually being addressed by the financial reforms currently being debated. While Animal Spirits may not provide a miracle-cure for our current predicament, it’s an important first-step in understanding the role of human psychology in driving our economy. On a scale of 1 to 10, where 10 would be a gastronomical delight, I’d give this one an 8. Go check it out!

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