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.

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.


Are the bond vigilantes coming?

Beware, the bond vigilantes are coming! Or are they?

Get the kids, get the dog, and grab whatever weapons you happen to have within arms reach, zombies are coming!  Now, I’m not talking about the raised dead, like we all saw on Thriller, but rather bond vigilantes, about to pull the plug on good old Uncle Sam because they perceive us as unable or unwilling to pay our debt.  At the G20 summit this week, President Obama argued that more Keynesian stimulus was necessary until employment recovered.  The rest of the G20 balked, opting instead of fiscal austerity, because they fear the bond vigilantes.  Economist Paul Krugman, Nobel laureate, believes you can put that weapon down:

“Yes, America has long-run budget problems, but what we do on stimulus over the next couple of years has almost no bearing on our ability to deal with these long-run problems. As Douglas Elmendorf, the director of the Congressional Budget Office, recently put it, “There is no intrinsic contradiction between providing additional fiscal stimulus today, while the unemployment rate is high and many factories and offices are underused, and imposing fiscal restraint several years from now, when output and employment will probably be close to their potential.” Nonetheless, every few months we’re told that the bond vigilantes have arrived, and we must impose austerity now now now to appease them. Three months ago, a slight uptick in long-term interest rates was greeted with near hysteria: “Debt Fears Send Rates Up,” was the headline at The Wall Street Journal, although there was no actual evidence of such fears, and Alan Greenspan pronounced the rise a “canary in the mine.” Since then, long-term rates have plunged again. Far from fleeing U.S. government debt, investors evidently see it as their safest bet in a stumbling economy. Yet the advocates of austerity still assure us that bond vigilantes will attack any day now if we don’t slash spending immediately.”

However, advocates for austerity want to cut off unemployment benefits, when the housing market, and the larger economy, is still on life support.  They want to fire teachers, firefighters, and policemen around the country by slashing state aid.  In the halls of power, you can hear faint echoes of Herbert Hoover.  These austerity advocates often talk about Japan’s lost decade, and the inability of government spending to lift that country out of its recession.  However, no less than the Economist, Bible to the global business elite, brings up the much more pertinent examples of Canada and Sweden:

“The advocates of austerity… base their argument on cases in the 1990s, when countries such as Canada to Sweden cut their deficits and boomed. But in most of these instances interest rates fell sharply or the country’s currency weakened. Those remedies are not available now: interest rates are already low and rich-country currencies cannot all depreciate at once. Without those cushions, fiscal austerity is not likely to boost growth.”

What would be a sensible action to take right now?  Well, how about finally tackling entitlement reform?  Sure sure, Republicans would never undertake bipartisan work on entitlements in their Party of No posture, but stepping outside of political reality, now is the perfect time for politicians to compromise and craft a sensible reform of Social Security.  If not now, when?  It would send the right signals to those (imaginary) bond vigilantes that everyone worries about so much, but more to the point, it would deal with the long-term deficit, which we will have to deal with sooner or later.  Politicians will always try to punt that football down the road, but who is to say that there will be a better opportunity in the future?