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.

And the Oscar goes to… a bank?

The 2011 Academy Awards, hosted this year by acting ingénues James Franco and Anne Hathaway, was an attempt by the Academy of Arts and Sciences to reach out to a new, younger audience.  By that measure, the Academy failed miserably, reaching 12% less viewers in the 18-49-age bracket.   Ultimately, the Academy’s strategy, to reach all audiences at once, was baldly transparent and ineffective.  The projected image of Bob Hope, who produced the funniest lines of the night, represented the Academy jumping the shark.

While The King’s Speech, a film about a British monarch overcoming a speech impediment, took the biggest honors of the night, the most competitive and interesting race was for Best Documentary.  Presenter Oprah Winfrey said that, “It has never been more important for us to see these stories to help us try to make some sense of the world we live in.” Five strong films entered, including Sebastian Junger’s Restrepo and Josh Fox’s Gasland. Inside Job, Charles Ferguson’s searing inquiry into the roots of the financial crisis, took the Oscar.  As Ferguson accepted his Oscar, he started by saying, “Forgive me, I must start by pointing out that three years after our horrific financial crisis caused by financial fraud, not a single financial executive has gone to jail, and that’s wrong,”

One can’t help but think that JP Morgan Chase (JPMC) foresaw Inside Job’s victory and the speech by Ferguson, as no less than four times during the Oscar broadcast, their “New Way Forward” commercial appeared, promoting JPMC as a key driver of our ‘recovery:’

Conveniently, JPMC released their annual 10-K financial statement one day after the Oscars, so we can put their claims in perspective.  In 2010, JPMC held just over $50 Billion in wholesale commercial loans to United States businesses, a significant drop from their commercial commitments in 2007 and 2008.  While they are committed to making $10 Billion available to small businesses, that doesn’t mean that they will actually make the loans.  Additionally, their offer of a second review seems reminiscent of the situation when you aren’t getting the assistance you need on the phone and ask to speak with a customer service representative’s manager.  Why is this process necessary, and what does it actually offer to the small businessperson?  More importantly, why are small businesses having trouble getting access to money in the first place?

The quandary over small business loans goes to a larger question: what did the bailout of our financial institutions, through the Troubled Asset Relief Program (TARP) and FED actions, accomplish, if we don’t yet have a strong recovery?   After the financial crisis the Federal Reserve and the Treasury Department bailed out many of our largest banks, including investment banks, through funds from TARP and through access to cheap money from the discount window at the FED.  Many of the banks were overleveraged, and these programs allowed them to recapitalize.  In essence, the government allowed these banks to repair their balance sheet by printing money, and forcing the public to take the loss through devalued currency.  The actions in late 2008 and early 2009 by Hank Paulson, Ben Bernanke, and Tim Geithner certainly prevented a collapse of our banking sector.  The TARP program remains universally unpopular, despite reports that even losses from loans to AIG won’t top $14 Billion, a significant drop from earlier estimates.

During the last few years, banks like JPMC and Goldman Sachs have made tidy profits and made tidy bonus payments, but that hasn’t necessarily translated into an economic recovery.  We have stronger banks, but not a stronger recovery.  The Excess Reserves of Depository Institutions (EXCRESNS) is a valuable lens with which to view this quandary.  In 2009, after nearly 50 years of being near zero, meaning that banks lent out as much as they could based on their reserves, the data jumps to hockey stick proportions.  You don’t have to believe me, you can see the data yourself on the FED’s website.  Many banks are standing pat on reserves that they could be lending.

While JPMC isn’t actually saying much in their Oscar ad, they do sound earnest and committed to a recovery.  I wonder how much that ad cost?  JPMC paid to lobbyists $6.2 Million in 2009 to help make the Dodd-Frank Financial Reform Bill to their liking.  What if JPMC lent that money out to small businesses in 2009, instead?  In retrospect, I think the Oscar voters missed out on an award-winning acting performance by JPMC.

What can key an economic recovery?  Lets look at the stimulus efforts to date, made up of both tax cuts and direct government expenditures.  John Maynard Keynes argued that both tax cuts and government spending would help to increase the GDP, but that government investments were far more effective, driving a more powerful Keynesian multiplier.  In essence, the expenditures recycle themselves more directly into the economy and have a larger impact, whereas tax cuts are often put into savings or used to pay off debt meaning that less money gets recycled back into the economy.

Republicans often argue that tax cuts ‘pay for themselves,’ relying on the unsubstantiated and discredited ‘Laffer curve;’ for example, the Republican House does not require tax cuts to be paid for in regards to the deficit.  With Republican governors continuing to reject direct government stimulus, as Wisconsin and Florida governors recently did with high-speed rail money, this means that our efforts to stimulate the economy will still hurt the deficit, but they will not be very effective.

However, the recent ‘Obama’ tax cuts, the extension of the Bush tax cuts including those on the top 2% of wage earners, amounts to Supply Side economics redux.  Capital gains cuts are similar in their effect to tax cuts, as the windfalls go to wealthy taxpayers who won’t spend the money immediately.  Supply Side economists argue that by reducing tax rates and eliminating regulation, businesses will be able to hire more workers, and increase the GDP.  To date, after many rounds of tax cuts for businesses, unemployment (and more importantly, underemployment) remains high.   Looking at the big picture, the actions of our government in response to the financial crisis is a bit like the Academy – trying to please a lot of different audiences at once, without delivering a clear, concise, and effective message.

Our mental models and the financial crisis

Cover of "The Divine Right of Capital: De...

Cover via Amazon

Marjorie Kelly, in her book The Divine Right of Capital, constructs a bold critique of the role that stockholders play modern corporations.     She compares stockholders to the aristocratic feudal lords of yore, who made rent on “assets” into perpetuity without lifting a finger.  Instead, Kelly argues that both the employees who work to create corporate wealth, and the communities that provide the resources necessary to create that wealth, should earn a larger share of the wealth.  Kelly examines the framework of the corporation as it was first conceived, how the corporations in the United States were initially granted state charters to only serve the public good, and how that public purpose was eroded in our courts.  Examining the state of affairs today, Kelly concludes that all players, including stockholders, CEOs, Wall Street firms, and even you and I, are all complicit, but no one is guilty:

“We fool ourselves if we think we can find the enemy somewhere.  Our anger at the system leaves us like the farmer in The Grapes of Wrath, who when his farm was repossessed couldn’t find anyone to shoot.  There isn’t anyone to shoot.  The problem is our internal maps, and rethinking those can require some vilification of outmoded views.  But we must remember that we’re vilifying the value system of wealth discrimination – not the wealthy themselves.  Respect for the right to attain wealth is integral to the American psyche.”  (Kelly 99)

Kelly is absolutely right here; we all operate based on the internal maps, with their arbitrary assumptions and logic, to try to make a good life for ourselves.  Certainly, when one examines the litany of shenanigans that occurred in the recent financial crisis, it is easy to spot villains like Bernie Madoff; when reading deft accounts of the crisis, like Michael Lewis’s The Big Short, it is easy to ask how our economic game could be rigged as it is, and how we could have been so blind to the massive speculative bubble that would take down the global economy.  However, Lewis’s narrative is perhaps the most relevant to Kelly’s critique here, because the 20 or so people that saw the asset bubble for what it was were outliers, consistently critiqued by the establishment.  Their mental models were slightly off from the mainstream, most memorably Michael Burry, the one-eyed medical school graduate who was obsessed with the stock market from the age 12, and built a successful stock-picking blog that he wrote in the wee hours as a resident into his own hedge fund.    However, the majority of operators in our economy are simply following the rules of the game, to the best of their ability.  The idea of the American dream, which is echoed whenever a mother tells a child, ‘you can do anything you want,’ is a critical part of the American psyche.  Kelly is attempting to shift our mental models, so that we can see that our current paradigm doesn’t quite live up to the ideals of that American Dream; we are not the ‘Land of Opportunity’ we think we are.

Kelley identifies a critical fault in the current paradigm: the idea that shareholders ‘own’ the company, and the companies they own are required to maximize shareholder return above all other concerns.  Employees, who’s knowledge and ideas create the wealth of the 21st century, should under that paradigm be paid as little as possible.  However, Kelly brings a different mental model to bear:

“The principle is simple: efficiency is best served when gains go to those who create the wealth.  Thus, instead of aiming to pay employees as little as possible, corporations should distribute employee rewards based on contribution – while recognizing that in any humane social order, a living wage is the basic minimum.  Likewise, corporations might aim for a decent minimum stockholder gain but drop their focus on maximum gain.  The legitimate goal is reward based on contribution.  Since the contribution of stockholders has shrunk dramatically, their gains should shrink also.  It simply defies market principles to continue giving speculators the wealth that employees create.” (Kelly 108)

In light is the recent Global Financial Meltdown, it is helpful to consider what role those speculators played in the inflating asset bubbles, and the growth of subprime mortgage bonds into the dominant investment vehicle between 2005-7.  But step back for a moment and consider what would have happened if the rising productivity of the last decade were not entirely bequeathed to stockholders, but if employees got their share?  What if communities, instead of giving tax breaks to draw corporations like Boeing to move, instead received their share, and invested it in our crumbling infrastructure and public schools?  In short, both individuals and communities would bear some of the fruit of their own industry.  The system would be more efficient, and given the recent speculative disasters, we certainly wouldn’t be any worse off.


Works Cited


Kelly, Marjorie. The Divine Right of Capital.  San Francisco: Berrett-Koehler, 2003.  Print.


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.

A visual illustration of why the housing market is broken

This is a diagram, put together by an expert on securitization, showing what has happened to his mortgage since he closed.  (Click image for a larger version).  This is insane!  If you missed out on the This American Life chronicling Toxie, a toxic mortgage bond the economic team at Planet Money dissected, it is worth checking out.  Does this make any sense?  Why do America’s best and brightest work on Wall Street, so they can engineer transactions like this one?

Keynes vs. Hayek: the sequel hiphopmaggeden

The guys who brought you ‘Fear the Boom and the Bust’, the Hayek vs. Keynes Hip Hop Smackdown are back.  They preview their new sequel here in front of an audience of Wall Street Tycoons.  The new video comes out in a month, with more lyrics and a new beat.  For now, check out these sweet econ rhymes, starting at about 1:30 of the Youtube clip.

Incidentally, if you missed the original video, here it is:

We didn’t see it coming?

I bet you didn’t think Robert Rubin and Lloyd Blankfein could sing this well!  Well, the Gregory Brothers, mavens of Autotune the News, produced this video together with the investigative reporters at ProPublica and the journalists at NPR’s Planet Money.  Their story on the actions of CDO managers at Merryl Lynch, Bank of America, and Citigroup identifies people who actually saw the financial mess coming and made it worse to make a few bucks for themselves.  This story pairs nicely with Michael Lewis’s The Big Short.