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Friday, May 08, 2009

"The Failure of the Economy & the Economists"

A much shortened version of Benjamin Friedman review of Akerlof and Shiller's Animal Spirits: and Shiller's The Subprime Solution:

The Failure of the Economy & the Economists, by Benjamin M. Friedman, NYRB, Review of Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George A. Akerlof and Robert J. Shiller; and The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do About It by Robert J. Shiller: By now there are few people who do not acknowledge that the major American financial institutions and the markets they dominate turn out to have served the country badly in recent years. ...

But despite the universal agreement that no one wants any more such failures once this one has passed, there is a troubling lack of attention to reforms that might prevent such a crisis from recurring. ... As in past financial declines, what is sorely missing in this discussion is attention to what function the financial system is supposed to perform in the economy and how well it has been doing it. ... Another fundamental issue that the current discussion has overlooked almost entirely is the distinction between the losses to banks and other lenders that reflect genuine losses of wealth to the economy, and other losses that don't. ...

Why has there been so little discussion of fundamental issues like this distinction among losses? Why is so little said about the trade-off between the goal of allocating the economy's capital efficiently and the need to shrink the enormous costs of the financial industry in doing so? One obvious reason is political. There is a long arc from Roosevelt's acceptance of a useful role for government institutions and government regulation to the conviction of Reagan and Thatcher that the government is never the solution but actually the problem. A second, closely related reason is ideological: the faith, personified by Alan Greenspan with his early dedication to the writings of Ayn Rand and his staunch opposition to regulations while chairman of the Federal Reserve, that private, profit-driven economic activity is self-regulating and, when necessary, self-correcting.

The economists George Akerlof and Robert Shiller suggest a third reason. In their view, the problem is also intellectual—a systematic failure of thinking on the part of their fellow economists. Taking the title of their new book from a phrase famously used by John Maynard Keynes, Akerlof and Shiller argue that what is missing in the worldview of today's economists is sufficient attention to "animal spirits," by which they mean the psychological and even irrational elements that figure importantly in so many other familiar aspects of personal choices and personal behavior, and that, they believe, pervade economic behavior too.

Akerlof and Shiller identify five distinct elements in what they call "animal spirits": confidence, or the lack of it; concern for fairness, that is, for how people think they and others should behave—for example, that a hardware store shouldn't raise the price of snow shovels after a blizzard despite the increased demand; corruption and other tendencies toward antisocial behavior; "money illusion," meaning susceptibility to being misled by purely nominal price movements that, because of inflation or deflation, do not correspond to real values; and reliance on "stories"—for example, inspirational accounts of how the Internet led to a "new era" of productivity. The omission of these five aspects of "animal spirits," they argue, blocks conventional economics from either understanding today's crisis or providing useful ideas for dealing with it. ...

[T]he ... question is whether Akerlof and Shiller succeed in making more of the different kinds of research they report on in Animal Spirits than the sum of the book's disparate parts. The answer is yes in some respects, no in others.

They succeed in demonstrating both the narrowness of mainstream macroeconomic thinking in recent decades and the stranglehold that this thinking has placed on the economics profession's ability either to explain phenomena like today's crisis or to advance potential solutions. ...

Akerlof and Shiller succeed, too, in demonstrating that conventional macroeconomic analyses often fail because they omit not just readily observable facts like unemployment and institutions such as credit markets but also harder-to-document behavioral patterns that fall within the authors' notion of "animal spirits." Confidence plainly matters, and so does the absence of it. ...

As they argue, these effects can plausibly be larger than the fluctuations attributable to more concrete factors, such as monetary policy or oil prices, that economists more typically incorporate in their analysis. Money illusion, by which people are influenced by purely nominal price movements, is also clearly important to some aspects of how the economy in aggregate behaves. ...

The effort to "clean up macroeconomics and make it more scientific," to impose "research structure and discipline," has proved disastrously confining. But what then? Is there more to Animal Spirits than a list of important influences for economists to try to take into account? Akerlof and Shiller believe they have proposed a new model for macroeconomic analysis. ...

There is a difference between a series of ideas about different aspects of economic behavior and an integrated account of macroeconomic fluctuations. Akerlof and Shiller are surely on the right track in pointing to elements that are missing from today's conventional models, and in arguing that incorporating them into mainstream macroeconomic analysis would help. But they have neither done this nor shown others how to. Hence their goal of replacing what macroeconomists teach their students is likely to be disappointed, at least for now.

And because what they have here is a set of examples of how "animal spirits" matter for specific aspects of economic behavior, not a coherently worked out theory of how the macroeconomy behaves, it is not surprising that Animal Spirits is also thin on suggestions for what to do about the current crisis. ...

But their silence on ... policy issues and their lack of a full-blown "theory" to replace the strait-jacketed macroeconomics of the past few decades do not undercut the force of Akerlof and Shiller's central argument. Their harsh judgment of current mainstream macroeconomic thinking is true, and they are right about the importance of what they call "animal spirits" to many of its crippling shortcomings. Animal Spirits provides an agenda for new thinking, and one well worth pursuing. ... [full article]

    Posted by on Friday, May 8, 2009 at 12:53 PM in Economics, Methodology | Permalink  TrackBack (0)  Comments (29)

          

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