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.


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.


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.


With tax bill, Congress restores biodiesel tax credit

In October, I toured Newport Biodiesel, and spoke with its founder, Nat Harris.  Newport Biodiesel is a remarkable local business that takes Waste Vegetable Oil from restaurants across Rhode Island and converts it to ASTM certified Biodiesel, which then heats homes and powers automobiles across New England.  When we met, Nat talked about some of the difficulties many in the biodiesel industry faced when the $1/gallon biodiesel Federal Tax Credit expired in January 2010.  However, Nat Harris and the rest of the nacent biodiesel industry are undoubtedly celebrating the retroactive extension of the tax credit through 2011, which will become official when the President signs the tax bill.

Why is biodiesel important?  I wrote about it here in detail, but for a quick primer, biodiesel emits fewer pollutants when it is burned; because it is created from waste products and plant matter, it has less than 50% of the life cycle carbon emissions than petroluem-based fuels.  This is not ethanol, it is an Advanced Biofuel that can be blended with petro-fuel to work year ’round.  More importantly, this is a domestic industry that takes material out of the waste stream and resuses it.  Biodiesel is sustainability.  And for President Obama, it is another victory in a Lame Duck session that is surprisingly bountiful.  The Senate may even have enough votes to repeal “Don’t Ask, Don’t Tell” this weekend.


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.