Akerlof and Shiller; "Animal Spirits"

Source:http://vootanker.blogspot.com/2011/02/akerlof-and-shiller-animal-spirits.html

"Animal Spirits" is a book on behavioral economics written by Robert Shiller and George Akerlof.
Both of the authors should be well known in economic circles. George Akerlof recieved the 2001
Nobel Prize in economics for his work on assymetric information, and Robert Shiller is famous for
the Case-Shiller Home Price Index.

"Animal Spirits" is a book inspired by John Maynard Keyne's famous book "The General Theory of
Employment, Interest and Money" from 1936. Keynes were a pioneer within the field today known
as behavioral economics, which is basically a field of economics that focus on the human
psychology in economic situations. Keynes suggested humans mostly base their choices upon
intuition and feelings(hence the term animal spirits) rather than carefully calculated expected
returns and probabilities. Keynes for example pointed out that the choice of investment by most
investors were not based on fundemental values and statistical projections, but on popularity and
feelings.

That last point is quite crucial in discussions regarding financial markets, because it is contrary to
what many academics believe today, namely that markets are efficient. The Efficient Market
Hypothesis suggests that financial markets correctly value all new information made public, and it
is thus not possible for a investor to make above average gains in for example the stock market over
time. The Efficient Market Hypothesis is quite controversial, and an increasing number of investors
and academics are currently raising serious questions about the hypothesis.

The authors also emphasize the importance of culture and social conditions in economics. This part
of the book is related to how economic disparities are developed between groups of people in a
society. The authors uses the Afro-Americans in the US as an example. Afro-Americans in general
have a lower per capita income than other groups. They also have higher crime rates, and drugs is a
much bigger problem than in the white population. "Animal Spirits" explains that this is the result
of psycholigical effects that culture have on us. It generates a feeling of "us" and "them", and it is
difficult to get out from such social division. This is in spite of the efforts taken to reduce the
difference between white and Afro-American communities.

"Animal Spirits" also presents a new view on the Phillips Curve. The Phillips Curve describes the
relation between inflation and employment, and it was considered mainstream economics in the 50s
and 60s. In the late 1960s Milton Friedman criticized the Phillips Curve on the basis that higher
inflation would make the unions demand inflation premiums when they bargained for wages. Thus
increasing inflation would only lead to higher inflation without the benefit of lower unemployment.
The Phillips Curve presented in "Animal Spirits" is somewhat different from the original Phillips
Curve. Shiller and Akerlof claims that because most people are not aware of inflation when inflation
is low and stable, they will not demand inflation premiums. It is only when inflation is high that
they will demand premiums, because most people will then be aware of it.

The book also looks into how psychological factors drives the economy and leads to bussiness
cycle. He uses the "roaring twenties" as an example of a period of excess and optimism, a lot like
the period from 1999-2008. According to the authors the boom in the 1920s was driven by loose

Vetle Øye Opheim,2011

regulations and a loose monetary policy. This pushed down risk premiums, and really pumped the
optimism in the US to dangerous levels. Everyone borrowed, spent and invested in stocks, but when
everyone is euphoric and risky, the risk of a massive economic bust grows.

I my self found the book quite compelling, and I did agree with a lot of the points made by the
authors. I still raise questions about the Phillips Curve though, even the alternative version offered
by the authors, but that's just one of the many points the authors raise, and is probably the only one
i'm a bit sceptical about. I find Shiller and Akerlofs views on how psychology a major part of how
people and maybe even businesses make decisions quite compelling.

Vetle Øye Opheim,2011