[R-G] [BillTottenWeblog] We simply do not know!

[Bill Totten]

by John Gray

London Review of Books (November 19 2009)

Animal Spirits: How Human Psychology Drives the Economy, and Why It
Matters for Global Capitalism by George Akerlof and Robert Shiller
(Princeton, 2009), ISBN 978 0 691 14233 3


The last two years, in which capitalism has suffered one of its periodic
shocks, have given John Maynard Keynes a new lease of life. Events have
demonstrated the limits of the theory that economies can be relied on to
be stable if they are lightly regulated and otherwise left to themselves.
There is now much talk of the paradox of thrift, whereby the rational
choices of individuals can prove collectively ruinous, and of the need for
government to counteract the inherently anarchic tendencies of markets.
Keynes has been revived because he understood that markets are very often
irrational. Unfortunately, few of those who urge that we go back to him
seem to have understood why he believed this.

Apart from a brief postscript to one of the chapters and a few remarks in
the preface, George Akerlof and Robert Shiller's Animal Spirits was
written before the current crisis. Yet, based on research undertaken over
many years, it can be read as prefiguring the current disillusionment with
economics. The trouble with prevailing theories, in Akerlof and Shiller's
view, is that they assume human beings are more rational than they
actually are. 'This book, which draws on an emerging field called
behavioural economics, describes how the economy really works', they
claim. 'It accounts for how it works when people really are human, that
is, possessed of all-too-human animal spirits'.

They point to five different ways in which these 'animal spirits' can
affect economic behaviour. First, the state of the economy depends on the
level of confidence we feel about the future, but confidence 'is not just
a rational prediction. It is the first and most crucial of our animal
spirits.' Second, a concern for fairness 'can trump economic motivations':
elementary economics teaches that a rise in demand for shovels after a
snowstorm should result in higher prices for shovels; but most people - 82
per cent of correspondents in a survey conducted by two behavioural
economists - believe that raising the price would be unfair. Third, the
actions of predatory corporations can have an impact on the entire
economy: the belief that Enron had acted in bad faith led to people being
'fed up with financial markets in general' a shift of a kind that is
'clearly within the realm of pure animal spirits'. Fourth, people make
many of their economic decisions without taking account of inflation:
instead of acting to maximise their real (inflation-adjusted) income, they
succumb to 'money illusion'. Finally, human behaviour is heavily
influenced by stories, narratives with a dramatic logic that drives people
to action. The internet boom at the start of the millennium was not just a
response to the development of a new technology; it expressed a view of
the world, including the belief that a new era had arrived in which the
economic cycles of the past had ceased to operate.

As Akerlof and Shiller represent them, each of these manifestations of
animal spirits shows behaviour being driven by forces other than reason.
None of them offers rational grounds for action in any sense that most
economists would recognise. Even so, the authors insist, these responses
must enter into any account of how economies actually work. If economists
have failed to explain repeated crises, it is because they have
interpreted economic activity through an unreal model of rational
decision-making. Thinking of human behaviour in this way allows them to
claim a high degree of precision for their discipline, which is presented
as a kind of applied mathematics. But they have left psychology out of
their equations.

A cogent critique of the theoretical excesses of mainstream economics,
Animal Spirits is well argued and also - no small virtue among economists
- pleasingly written. At the same time, it is hardly the revolution in
thinking that its authors claim. The observation that markets are prone to
violent swings of emotion, recurrent illusions and powerful stories is a
piece of perennial wisdom that was summarised in Charles Mackay's Memories
of Extraordinary Popular Delusions and the Madness of Crowds, published in
1841. More recently, George Soros has insisted that market behaviour is a
reflexive process intrinsically liable to lead to cycles of boom and bust,
as the beliefs and decisions of participants are reinforced by a desire to
go with the trend until the market becomes unsustainable.

The fact that markets are flawed seems novel only in the context of the
economic orthodoxy that prevailed between the wars, and in the run-up to
the recent crisis. It is wrong to imply, as Akerlof and Shiller do, that
the classical economists believed otherwise. 'Just as Adam Smith's
invisible hand is the keynote of classical economics', they write,
'Keynes's animal spirits are the keynote to a different view of the
economy - a view that explains the underlying instabilities of
capitalism'. Here they are endorsing the caricature of Smith propagated by
neoliberal ideologues anxious to confer a distinguished patrimony on an
illegitimate intellectual offspring. Certainly, the 'invisible hand' is
one of Smith's central ideas, but he never saw it as working in a
mechanical fashion. A network of hidden adjustments whereby conflicting
interests could be reconciled, in a complex process that always involved
human emotions, the invisible hand was neither all-powerful nor uniformly
benign. It could be thwarted by collusion among businessmen, and when
given free rein its social effects could be seriously harmful. Like other
thinkers of the Scottish Enlightenment, Smith understood the
imperfectability of human institutions. He was concerned about the ways in
which free markets detached people from communities, and some of these
worries fed into the theory of alienation developed by that other
celebrated classical economist, Karl Marx.

If Akerlof and Shiller's grip on the history of economic thought is shaky,
they also fail to grasp why Keynes rejected the idea that markets are
self-stabilising. Throughout Animal Spirits they portray him as
reintegrating psychology with economic theory. No doubt this was one of
Keynes's goals, but it is not his most fundamental revision of economic
orthodoxy. Among his other accomplishments he was the author of A Treatise
on Probability (1921), in which he tried to develop a theory of 'rational
degrees of belief'. By his own account he failed, and in his canonical
General Theory of Employment, Interest and Money (1936) he concluded that
there was no way anyone could make forecasts. Future interest rates and
prices, new inventions and the likelihood of a European war cannot be
predicted: there is no 'basis on which to form any calculable probability
whatever. We simply do not know!' For Keynes, markets are unstable less
because they are driven by emotion than because the future is unknowable.
To suggest that the source of market volatility is unreason is to imply
that if people were fully rational markets could be stable. But even if
people were affectless calculating machines they would still be ignorant
of the future, and markets would still be volatile. The root cause of
market instability is the insuperable limitation of human knowledge.

Later economists have made much of a distinction between risk, which can
be assessed in terms of quantifiable likelihood, and uncertainty, where
probabilities cannot be attached to possible outcomes. The trouble is that
when attempting to forecast the course of the economy we often cannot
confidently distinguish between the two. Even our list of possible
outcomes may turn out to have omitted the ones that are most important in
shaping events. Such an omission was one of the factors that led Long-Term
Capital Management, a highly leveraged hedge fund set up by two Nobel
Prize winning economists, to fail in 1998-2000. The information used in
applying the formula did not include the possibility of such events as the
Asian financial crisis and Russia's default on its sovereign debt, which
destabilised global financial markets and helped destroy the fund. The
orthodoxy that came unstuck with the collapse of LTCM was not faulty
because it neglected the vagaries of human moods; its mistake was to think
that the unknown future could be turned into a set of calculable risks
and, in effect, conjured out of existence, which was impossible. Several
centuries earlier, Pascal - one of the founders of probability theory -
had come to the same conclusion, when in the Pensées (1670) he asks
ironically: 'Is it probable that probability brings certainty?'

The central flaw of the economic orthodoxy against which Keynes fought in
the 1930s was to imagine that an insoluble problem - human ignorance of
the future - had been solved. The error was repeated in the 1990s, when
economists came to believe that complex mathematical formulae could tame
uncertainty in the murky world of derivatives. Steeped in history as they
were, this was a delusion that none of the classical economists
entertained. It began to shape economics only towards the end of the 19th
century, with the rise of Positivism, according to which the natural
sciences are the only legitimate repository of human knowledge. It was the
formative influence of this philosophy on the Chicago School that enabled
the orthodoxy of the 1930s to re-emerge triumphant, and the result was an
immense boost to the prestige of economics as a discipline. Economists
could claim to be scientists, who with the aid of their mathematical magic
could pierce the veil that conceals the future.

The hegemony of Positivism in economics obscured Keynes's scepticism about
probabilistic knowledge, his most important contribution to the
discipline. G L S Shackle set Keynes's argument out systematically in his
neglected masterpiece Epistemics and Economics: A Critique of Economic
Doctrines (1972). Shackle is probably the only significant economist to
have been influenced both by Keynes and by his arch-rival, F A Hayek. He
knew both of them well, but argued that neither had digested the full
implications for economics of our ignorance of the future. Hayek said that
governments could never know enough to plan the economy successfully - a
claim vindicated by the miserable record of central planning in Communist
countries. At the same time, he attributed near omniscience to markets,
and never doubted that if left to its own devices the economy would
liquidate mistaken investments and return to equilibrium. Against this,
Keynes had shown that there is no market mechanism that ensures revival;
economic contraction can be self-reinforcing, and only government action
can then create a way out.

Shackle took Keynes's argument a step further, and showed that no economic
policy can ensure economic stability indefinitely. 'Keynesian' policies
are no exception to this rule. Deficit financing and monetary expansion
may have worked well in the conditions that existed after the Second World
War. It is not clear that they will be so effective today, when
globalisation has brought a freedom of capital movements that did not
exist then. The lesson of Shackle is that we must be resourceful in
devising new remedies, while not losing sight of the fact that none of
them works for long.

Akerlof and Shiller claim that their account of the role of psychology
helps to explain the financial crisis. 'Our theory of animal spirits',
they say, 'provides an answer to a conundrum: why did most of us utterly
fail to foresee the current economic crisis? How can we understand this
crisis when it seems to have come out of the blue with no cause?' They are
right that part of the answer lies in an intellectual default within
economics, but they seem oblivious of the role of ideology in producing
this default. The deformation of economics was not the result only of
factors internal to the discipline, it was also part of the short-lived
Western triumphalism that followed the end of the Cold War.

Those were the years when slackers throughout the world were enjoined to
submit themselves to the rigours of 'the Washington consensus' - a mix of
dogmatic policy prescriptions and hypocritical rhetoric that enjoyed the
support of the great majority of economists. According to that consensus,
the market regime that was installed in Britain, the US and a few other
countries from the 1980s onwards could not only ensure stability and
promote steady growth there but was a model - the only possible model -
for countries everywhere. The one truly rational economic regime, free
market capitalism, was also the most productive. As such it was bound to
drive every other system out of existence, and would eventually be adopted
worldwide. This faith in the universal spread of free markets animated
much of the thinking of the American-led institutions overseeing the world
economy, such as the IMF. Along with economists in university departments
in much of the world, these institutions succumbed to a quasi-religious
belief that the free market was the germ of a single, universal economic
system.

Not everyone swallowed this creed. It was not accepted in China, which
then as now displayed a well-founded contempt for Western advice - an
attitude that has much to do with its astonishing economic success.
Whether in the face of global recession China can continue to grow at the
same rate is unclear - as Keynes would have put it, we simply don't know.
Nonetheless, its emergence as an economic superpower poses questions for
economics that are harder to answer than is generally recognised.
Economists do not always take the neoliberal party line, according to
which growth can be sustained only in a regime of deregulated capitalism;
the evidence of history precludes any such simple-minded view. Liberal
capitalism has achieved striking results (though in the US, often against
the background of trade protection), but so have many varieties of
dirigisme, from rapid growth in late tsarist Russia to Asian market
economies in the decades after 1945. Economic historians whose minds are
not befogged by ideology accept that there are many routes to growth. At
the same time, nearly all Western-trained economists insist that sustained
growth is impossible in the absence of a legal system that allows the
independent rule of law and secure rights to private property. Without
this framework, they believe, there will not be the incentives required
for long-term saving and investment.

But China has achieved the largest and fastest industrialisation in
history without having such a legal system. Until recently, Western
economists, along with other Western observers, were adamant that China
would continue to be successful only to the extent that it mimicked
Western practice. Now that Western economies are in trouble this
confidence has been shaken, and China is once again being perceived as
alien and dangerous. There is no real attempt to try to understand the
sources of its success. Like other branches of the study of society,
economics remains culturally parochial, and its underlying concepts based
on a few centuries of Western experience.

To their credit, Akerlof and Shiller do discuss how motives not normally
regarded as economic have contributed to China's growth. An appeal to
patriotism helped persuade villagers to contribute to the regime's plans
for economic growth in the 1970s, so that 'a national story began to grip
the imagination of the people of China, a story of individual effort and
sacrifice'. One may doubt whether this is the whole story, but it is
suggestive, because it illustrates the unreality of the notion that the
behaviour of markets is governed by strictly 'economic' motivations. Much
of Akerlof and Shiller's analysis is an implicit criticism of this notion,
and yet - in conformity with the narrow explanatory model of market
behaviour they aim to criticise - they invoke it whenever they suggest
that deviations from economic rationality account for instability in
markets. They don't appear to realise that the assumption of a categorical
distinction between 'economic' and 'non-economic' motives is one of the
chief reasons recent economic theory has been so consistently remote from
reality.

Keynes and the classical economists before him knew that there is no realm
of market exchange that obeys laws of the kind that can be formulated in
the natural sciences. Economics and politics are not separate branches of
human activity, and economic life cannot be studied independently of
social divisions and political conflicts among populations, along with
their cultures and religions. Familiar to Keynes and most of the
economists of his generation, these truisms have been forgotten, or
rejected, by many economists today. The result is an economic imperialism
that tries to explain every human activity in terms of a conception of
rational action that does not work even when applied to the behaviour of
markets.

Of course, there is a standard response to these observations, which is
that unrealism in economic theories doesn't matter. As developed by Milton
Friedman, among others, this is in effect a version of instrumentalism, a
tenable position in the philosophy of science. For instrumentalists, the
goal of science is not a true representation of the world; it is to
organise our observations into a theoretical framework that serves
practical goals, such as prediction and control. But what practical goals
have been served by the type of economics dominant over the past two
decades? It has been useful neither in making predictions nor in
responding to unforeseen developments.

Akerlof and Shiller intend their analysis to contribute to an intellectual
reformation in economics, as a consequence of which the discipline will
become more useful to policy-makers. It must be doubted, though, that the
authors will succeed in persuading economists of the inadequacy of the
conception of rational action. The profession is one of the few areas of
human activity in which that conception is applicable. In its
intra-academic varieties, at any rate, economics is insulated from the
world not only by its narrow explanatory methodology but also because it
rewards the mathematical modelling that resulted in nearly all of its
members failing to anticipate the financial crisis. As institutionalised
in universities, the notion of rational decision-making is
self-perpetuating. Economics as currently practised may have only a slight
grip on market behaviour, but it seems to be powerfully predictive of the
behaviour of economists.

_____

John Gray’s False Dawn: The Delusions of Global Capitalism, first
published in 1998, was reissued in October with a new section on the
global financial crisis. ISSN 0260-9592 Copyright (c) LRB Ltd, 1997-2009

http://www.lrb.co.uk/v31/n22/john-gray/we-simply-do-not-know?


TO POST A COMMENT, OR TO READ COMMENTS POSTED BY OTHERS, please click
on the word "comment" highlighted at the end of the version of this
essay posted at http://billtotten.blogspot.com/