Animal Spirits

On the cover of the paperback version of George Akerlof and Robert Schiller’s Animal Spirits, the blurb, from Time’s Michael Grunwald, is “Animal Sprits [is]… the new must read in Obamaworld.”  In March of 2011, two years after President Obama took office and Animal Spirits was first published, it is clear that the President and his economic team were reading from this playbook.  However, it is also clear that the President missed an opportunity to communicate to the public why he took the actions that he did.  As the United States moves forward in a so-called jobless recovery, and divisiveness and friction rule across D.C. and the country, our economic policy is hobbled and scattershot.  Support for the American Recovery and Reinvestment Act has wavered in the last two years, and the public’s drop in support killed any political will for more stimulus spending.  The public apprehension and political failures are ironic, actually, because in Animal Spirits, Akerlof and Schiller write about an earlier misinterpretation of Keynesian economics, during the Great Depression.

In 1936 John Maynard Keynes’ The General Theory of Employment, Interest, and Money was published.  Keynes charted a course between classical economists that argued that less regulation would allow private markets and rational actors, via the famous ‘invisible hand,’ to create jobs, and socialists that argued for the state to direct the economy.  Instead, Keynes took issue with the idea that only rational actors governed the economy; he believed that noneconomic, non-rational, animal spirits actually caused involuntary unemployment and economic fluctuation.  The government should not be too authoritarian, like the socialists argued, but it should also not be too permissive, like the classical economists argued.  Unfortunately, in an effort to create consensus with classical economists, supporters of Keynes removed most of the animal spirits, hoping that they could convince the broad public as quickly as possible to adopt Keynes’ fiscal policy prescriptions (just like President Obama allowed political expediency to rule his economic platform).  Unfortunately, this watered down theory was vulnerable to critique by neo-classical economists like Milton Friedman.  The central thesis of Akerlof and Schiller’s book is that these animal spirits, cast off in the midst of the Great Depression, remain a prime cause of our contemporary economic difficulties.  In fact, these ideas have emerged once again in the field of behavioral economics.

There are five animal spirits that the authors resurrect from The General Theory:

1) Confidence, the trust and belief that leads rational actors to make some irrational decisions, which amplifies business cycles

2) Fairness, often pushed to the backburner in economic textbooks, often trumps economic concerns and impacts both wages and prices

3) Corrupt Behavior and Bad Faith, economic activity with sinister motivation, was clearly evident in the recent economic crisis and recession, but can be clearly traced back through all of the major economic bumps in our past

4) Money illusion, disavowed by neo-classical economists like Milton Friedman, remains a contemporary concern as people continue to be confused about the impact of inflation and deflation

5) Stories, the narratives we create to describe human experience, often seem true and nurture speculative bubbles (like the housing bubble) until the bubble pops and the story changes

In the aftermath of the global economic shock, when many of the great economies of the world continue to stumble towards recovery, Akerlof and Schiller’s analysis is perfectly timed.  They clearly trace the impact of these animal spirits on the economy, from the Great Depression through the stagflation of the 1970s, through the recessions and the Savings & Loans crises of the 1980s, the recession and the tech bubble of the 1990s, and finally to the Enron debacle, the housing bubble, and the jobless recoveries of our recent past.  Akerlof and Schiller are true Keynesians; they appreciate the power of the free market to create economic opportunity, but they also appreciate the damage that these animal spirits can make in the economy.  The vast neo-classical deregulation that started in the 1970s and continued through the last decade did not take into account these Animal Spirits, and the vast economic turmoil was the result.

Confidence is one of the most important animal spirits – it leads ‘rational actors’ to what Federal Reserve Chairman Alan Greenspan described as “Irrational exuberance.”  If one looks back to the stock market of the 1890s or the 1920s, or the tech and housing bubble of our recent past, confidence is clearly evident.  Remember in 2004 when some of your friends said that housing prices could never fall?  That is confidence gone astray, irrational exuberance.  That is also a story that we all told each other, which seemed irrefutable logic, until it wasn’t.

Fairness has a big impact on unemployment. The neo-classical theories about how a labor market would clear itself revolve around wage efficiency, the idea that employers will pay the lowest wage and employ as many people as possible.  Unfortunately, the labor contract is more complicated than that, and the transaction only starts when the wage is agreed upon.  Schiller and Akerlof show that wages vary a great deal, and employers often pay more than they need to, to secure a motivated and skilled workforce.  Fairness affects both the employer and the employee.  The wage that workers deem fair is almost always above the market-clearing wage; this ensures that wages will remain sticky even during economic downturns, despite the fact that the ranks of the unemployed grow.

Money illusion also impacts wages; neo-classical economists argue that there is a Natural Rate of unemployment, but wage rigidity is partly due to the fact that people are largely unaware of the impact of inflation or deflation on their purchasing power.  A survey they conducted with a group of economists and a second group representing the general public shows the money illusion clearly: reacting to the statement “I think if my pay went up I would feel more satisfaction… even if prices went up as much,” 90% of the economists disagreed, while 59% of the general public agreed.  Fairness and money illusion clearly affect the setting of wages, behind the scenes of economic logic.  Akerlof and Schiller argue that we should “fire the forecaster,” and forget, once and for all, the myth that capitalism is pure.  They argue that safeguards must be built to protect the general public from the excesses of capitalism.  They also make clear that the stories that we tell each other are often irrational and exaggerated, and we must be protected from these exaggerations.

Like I mentioned above, it is clear the Obama Administration used Animal Spirits as a playbook in their efforts to prevent the economy from falling into a Depression.  Schiller and Akerlof advocated the use of the Discount window, as well as other provisions taken by both the Federal Reserve as well as the Treasury Department to prop up the banks.  To their credit, they also predicted that “the injections may make the banks richer, and therefore less likely to become insolvent, but they will not necessarily lend more money.”  As a result, the Government ended up taking extraordinary measures to ensure that money was available for mortgages and loans.

Ultimately, the actions taken by the Administration fell short of what Keynes, or Schiller and Akerlof would advocate.  The stimulus was insufficient, and the government did not act aggressively enough to regulate the banks.  But like the Gulf Oil spill last summer, I think the biggest loss was the failure to take advantage of the moment to educate the General Public of the external costs of our capitalist economy.  If a better effort were made to explain to the general public the Animal Spirits, how they impact the economy, and the logic of the stimulus and TARP, our response could have been more sustained, more consistent, and less contentious.  Keynesian economics could have stepped into the clear light of day, but instead the lessons of these animal spirits and their impact on the economy remain lost to much of the general public.  Because the problem of Too Big To Fail was not confronted, we will undoubtedly once again be in a position to deal with the consequences of leverage and risk that these global institutions create.


A Presidential moment

I am in Vermont this weekend, but I wanted to leave you with this; if you haven’t seen it already, it is one of the finest speeches this President has given, and one worthy of those lost in Tucson.


A review of 13 Bankers

When you talk with Conservatives about regulation, they will generally tell you that government regulation is too pervasive and ineffective; additional regulation is out of the question, and existing regulation should be simplified.   Those same conservatives often blame the financial crisis and the Great Recession on government involvement, and claim that if only the markets were free of government interference, rational actors would allow the markets to regulate themselves.  However, deregulation during the last three decades eliminated most of the protections put in place after the Great Depression, and put us in a hole we have yet to dig ourselves out of.

Simon Johnson and James Kwak, creator of The Baseline Scenario blog and authors of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, examine the long history of financial regulation and deregulation in their recent book.  They show that, without question, the Wall Street banks continue to hold inordinate power over our government and the U.S. economy.  They carefully trace the bipartisan financial deregulation that began under Ronald Reagan but continued through each successive administration, leading to the near collapse of the Global economy:

“Never before has so much taxpayer money been dedicated to save an industry from the consequences of its own mistakes.  In the ultimate irony, it went to an industry that had insisted for decades that it had no use for government and would be better off regulating itself – and it was overseen by a group of policymakers who agreed that government should play little role in the financial sector.”

For example, Johnson and Kwak explain the SEC agreement of April 28, 2004 that allowed the five large investment banks (Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Sterns) to calculate their own net capital based on internal models, rather than using standard models, allowing them to expand their leverage extensively for the next three years.  In fact, the regulation put in place by FDR after the Great Depression was systemically dismantled, and 13 Bankers shows how that dismantlement created massive financial institutions that were not only Too Big to Fail, but too powerful to control:

“The fact that their failure could entail the loss of millions of jobs gave the banks the power to dictate the terms of their rescue.  If the government insisted on paying market prices for the toxic assets, or insisted on taking majority control, the banks could simply refuse to go along, secure in the knowledge that the government would have to come back to the table.”

13 Bankers examines many common assumptions about the financial crisis; for example, conservatives tend to blame the entire crisis on Fannie Mae, Freddie Mac, and the Democratic Party.  However, Johnson and Kwak artfully disarm that claim:

“The riskiest mortgages, however – the ones that pushed the housing bubble to dizzying heights – were simply off-limits to Fannie and Freddie.  The [Government Sponsored Enterprses] could not buy many subprime mortgages (or securitize them) because they did not meet the conforming mortgage standards… ultimately regulatory constraints prevented them from plunging too far into subprime lending.  As housing expert Doris Dungey wrote, ‘the immovable objects of the conforming loan limits and the charter limitation of taking only loans with a maximum [loan-to-value] ratio of 80%… plus all their other regulatory strictures, managed fairly well against the irresistible force of innovation.’”

In short, the banks lobbied for years to remove the regulations that limited their size and scope; they developed complex financial instruments that were impossible to understand without a PhD from M.I.T.; they used those instruments to hide risk inside AAA rated securities that ultimately plummeted in value, and to move debt off their books; and finally, they had the nerve to complain about government interference after taxpayers backed up those risky bets.

Last summer, the Financial Reform Law was finally passed by Congress and signed by the President.  On The Baseline Scenario, Simon Johnson quickly identified the missing ingredient in the new regulation: it does nothing to reduce the size of institutions that are Too Big To Fail.  In 13 Bankers, Johnson and Kwak examine some common arguments about large banks, that they supposedly gain economies of scale, and that our large corporations require large, multi-national banks.   In fact, those claims “suffer from a shortage of empirical evidence.”  Johnson and Kwak provide good evidence to the contrary; for example, Johnson & Johnson used 11 different banks in their 2008 debt offering, and 13 different banks in their 2007 debt offering.

13 Bankers clearly identifies the systemic risk that TBTF banks offer, and warns of an even more dangerous crisis to come in the next financial cycle.  One of the main reasons is that TBTF institutions are effectively subsidized by the government, getting money for lower interest rates than smaller competitors; this occurs because investors know the government will always bail out TBTF institutions; this competitive advantage will provide the TBTF institutions a strong incentive to take excess risk.  Ultimately, until TBTF institutions are reduced in size, they will remain dangerous to long-term economic health.  Johnson and Kwak propose that commercial banks be limited to 4% of GDP and investment banks to 2% of GDP.  This would affect only six institutions: Bank of America (currently at 16% of GDP, JP Morgan Chase (14% GDP), Citigroup (13% GDP), Wells Fargo (9% GDP), Goldman Sachs (6% GDP), and Morgan Stanley (5% GDP). The goal would be to allow these banks to fail without taking down the entire economy with them.

13 Bankers will give you a good understanding of how bankers and the government have navigated the regulatory question over America’s history, and what caused the financial crisis.  The book also provides an excellent prescription for tackling the TBTF problem.  The Baseline Scenario is also an excellent resource, updated daily.


With the end of DADT, integrity restored to Military

Today the Senate voted, 63-33, to end the controversial “Don’t Ask, Don’t Tell” policy.  I served as a Naval Officer for eleven years, and saw firsthand the impact of DADT on men and women who pledged to serve, and potentially give their life, for their country, and yet were forced to lie about who they were.  One of the most important values of the U.S. Military is integrity; DADT was the antithesis of integrity as a policy.  All we heard from Republicans like John McCain in days leading up to the vote was how they threatened to withhold support of the New Start Treaty with Russia, even in the face of overwhelming support for ending DADT.  This is yet another victory for the President, a historic accomplishment akin to the end of segregation in the military.


Stimulus II the “swindle of the year”; Biogas powers Kristianstad, Sweden

Check out this excellent column by Charles Krauthammer of the Washington Post, on how the President swindled the Republicans:

“If Obama had asked for a second stimulus directly, he would have been laughed out of town. Stimulus I was so reviled that the Democrats banished the word from their lexicon throughout the 2010 campaign. And yet, despite a very weak post-election hand, Obama got the Republicans to offer to increase spending and cut taxes by $990 billion over two years. Two-thirds of that is above and beyond extension of the Bush tax cuts but includes such urgent national necessities as windmill subsidies. No mean achievement. After all, these are the same Republicans who spent 2010 running on limited government and reducing debt. And this budget busting occurs less than a week after the president’s deficit commission had supposedly signaled a new national consensus of austerity and frugality. Some Republicans are crowing that Stimulus II is the Republican way – mostly tax cuts – rather than the Democrats’ spending orgy of Stimulus I. That’s consolation? This just means that Republicans are two years too late. Stimulus II will still blow another near-$1 trillion hole in the budget.  At great cost that will have to be paid after this newest free lunch, the package will add as much as 1 percent to GDP and lower the unemployment rate by about 1.5 percentage points. That could easily be the difference between victory and defeat in 2012. Obama is no fool. While getting Republicans to boost his own reelection chances, he gets them to make a mockery of their newfound, second-chance, post-Bush, Tea-Party, this-time-we’re-serious persona of debt-averse fiscal responsibility. And he gets all this in return for what? For a mere two-year postponement of a mere 4.6-point increase in marginal tax rates for upper incomes. And an estate tax rate of 35 percent – it jumps insanely from zero to 55 percent on Jan. 1 – that is somewhat lower than what the Democrats wanted.”

I can’t believe that Rhode Island Democrats are still complaining about the extension of tax cuts for the top 2%.  This is an outstanding political achievement on the President’s part, and much needed stimulus.  Krauthammer is right, this stimulus represents the President pulling a rabbit out of a hat.

On another note, check out this biogas plant in Sweden. The town of Kristianstad no longer uses oil, natural gas, or coal to heat its homes or power its cars.  It generates biogas from waste agricultural products and other waste, including potato peels, manure, used cooking oil, stale cookies and pig intestines.  Fantastic!  In the United States, we have only 151 biomass digesters.  Most of our waste just ends up in landfills, where often the methane is not even tapped.

 


Network vs. cluster politicians

President Barack Obama and Senator Ted Kennedy...

Image via Wikipedia

David Brooks writes today about the criticism that President Obama has received this week, from Paul Krugman and countless others, over the tax compromise that he made with the GOP.  Brooks defines the President as a ‘Network’ liberal, and his liberal critics as ‘Cluster’ liberals:

“Cluster liberals (like cluster conservatives) view politics as a battle between implacable opponents. As a result, they believe victory is achieved through maximum unity. Psychologically, they tend to value loyalty and solidarity. They tend to angle toward situations in which philosophical lines are clearly drawn and partisan might can be bluntly applied. Network liberals share the same goals and emerge from the same movement. But they tend to believe — the nation being as diverse as it is and the Constitution saying what it does — that politics is a complex jockeying of ideas and interests. They believe progress is achieved by leaders savvy enough to build coalitions. Psychologically, network liberals are comfortable with weak ties; they are comfortable building relationships with people they disagree with. This contrast is not between lefties and moderates. It’s a contrast between different theories of how politics is done. Ted Kennedy was a network liberal, willing to stray from his preferences in negotiation with George W. Bush or John McCain. Most House Democrats, by contrast, are cluster liberals. They come from safe seats, have a poor feel for the wider electorate and work in an institution where politics is a war of all against all.”

Brooks is trapped in the fuzzy center, with the vanishing moderates.  His analysis of the political climate today is crystal clear, and he is exactly right, the President did achieve a victory with this tax compromise.  The problem with politicians that give no quarter is that the major problems we face demand compromise and cooperation.  The President wants to tackle comprehensive tax reform in the Spring; progress on that difficult issue will be hindered by cluster politicians.  The main reasons I originally became a supporter of the President, after his 2004 Convention speech, were that I saw a Great Communicator in the mold of Reagan, and a network politician willing to work across the aisle.  This is the perfect opportunity for the President to play to his strengths.

With the 2012 election approaching, Paul Krugman is right about one thing: many Republicans will be working to sabotage the President because they think that will deliver the White House to the GOP.  The problem with the GOP game plan is that the American people will not stand for two years of stalemate.  GOP opposition to the Health Bill for 9/11 workers is the perfect case in point.


Politicians behaving like adults: triangulation and tax policy

David Frum is one of the rare Conservatives that I take at face value, especially after his response to the passage of Health Care, Waterloo:

“We followed the most radical voices in the party and the movement, and they led us to abject and irreversible defeat. There were leaders who knew better, who would have liked to deal. But they were trapped. Conservative talkers on Fox and talk radio had whipped the Republican voting base into such a frenzy that deal-making was rendered impossible.”

He wrote another recent essay, after the mid-term elections, in which he meditated on the lessons that Conservatives have failed to learn:

“The U.S. political system is not a parliamentary system. Power is usually divided. The system is sustained by habits of cooperation, accepted limits on the use of power, implicit restraints on the use of rhetoric. In recent years, however, those restraints have faded and the system has delivered one failure after another, from the intelligence failures detailed in the 9/11 report to the stimulus that failed to adequately reduce unemployment, through frustrating wars and a financial crash. The message we hear from some Republicans — “this is no time for compromise” — threatens to extend the failures of governance for at least two more years. These failures serve nobody’s interest, and the national interest least of all.”

Yesterday, President Obama forged a compromise with the GOP on tax policy which extends all Bush era tax rates for two years, but also extends unemployment benefits, adds a temporary payroll tax cut to help the working class and continues tax breaks for parents and students.  He gave up on a promise to end the tax cuts for the richest Americans, in return for gains aimed at the Middle Class.  This is, according to observers, “messy, combustible and painful” bipartisanship, President Obama plunging “headlong into the political calculus known as triangulation.”  What can we make of this?  What does it portend for the future?

Certainly, the President recognizes that the 2012 election is not going to be won through obstructionism and ideological purity, but rather through compromise and policy.  David Frum also recognizes this, and is trying to push the GOP to remove themselves from their closed information systems (FOX), appreciate the power of government safety nets like social security, and move from obstructionism towards clear policy and compromise:

“If Republicans reject Obama-style fiscal stimulus, what do they advocate instead? A monetarist might recommend more money creation, even at the risk of inflation: “quantitative easing,” as it’s called. Yet leading voices in the Republican Party have convinced themselves that the country is on the verge of hyperinflation — a Weimar moment, says Glenn Beck. But if fiscal stimulus leads to socialism, and quantitative easing leads to Nazism, what on earth are we supposed to do? Cut the budget? But we won’t do that either! On Sean Hannity’s radio show, the Republican House leader John Boehner announced just before the election that one of his first priorities would be the repeal of the Obama Medicare cuts.”

How much will the GOP work with the President and Democrats during the next two years, leading up to the Election?  The President campaigned as someone who could cut through the old ways of Washington, and work with Republicans. However for the last two years, as Frum wrote, Republicans “would make no deal with the administration. No negotiations, no compromise, nothing. We were going for all the marbles.”  This tax policy is a compromise won by the White House, and a departure point for both parties going forward.

The Tea Party base of the party demands strict ideological purity, but Independents want the parties to work together.  The 2012 Presidential election will partly come down to how successful each party is in reaching those Independents.  Will the President be able to channel Bill Clinton and win a resounding re-election victory?  The pace of the economic recovery will play a big role in that, but so will the level of leadership that comes from the White House.

 

 


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