This book is a landmark book in Economics. After Newton in Physics, Alfred Marshall tried to make Economics as a rational science. He introduced supply and Demand curves similar to Analytical Geometry. In 20th century end, Economics ended with lot of equations which common man can not understand.
If we go through classics like Adam Smith's The Wealth of Nations, Ricardo's On the principles of Political Economy and Taxation, Karl Marx Capital , Alfred Marshall's Economics, Ludwig Von Mises's Human Action, we cant find too much mathematics.
From 1970s , due to the revolution in Finance , Mathematics took a greater part in Economics. Just go through some books on Derivatives, Options and Hedge funds. Your brain may blow up!
When most of the Economists forgot the reality of how Human psychology drives the Economy, Nobel Laureates Akerlof and Shiller woke up from sleep and wrote a classic , Animal Spirits- How Human Psychology drives the Economy and why it Matters for Global Capitalism.
According to my view, this book will have a huge impact in coming generation as the Keynes General theory of Employment, Interest and Money had in 1930s. Let us wait and watch.
Some of the illuminating passages from this book are as follows:
" To Understand How economics work and how we can manage them and prosper, we must pay attention to the thought patterns that animate people's ideas and feelings, their animal spirits. We will never really understand important economic events unless we confront the fact that their causes are largely mental in nature."
"Part One of this book will describe five different aspects of animal spirits and how they affect economic decisions-
confidence
fairness
corruption and antisocial behavior
money illusion
stories
- The cornerstone of our theory is confidence and the feedback mechanisms between it and the economy that amplify disturbances.
- The setting of wages and prices depends largely on concerns about fairness.
- We acknowledge the temptation toward corrupt and antisocial behavior and their role in the economy.
- Money illusion is another cornerstone of our theory. The public is confused by inflation or deflation and does not reason through its effects.
- Finally, our sense of reality, of who we are and what we are doing, is intertwined with the story of our lives and of the lives of others. The aggregate of such stories is a national or international story, which itself plays an important role in the economy.
Part two of this book describes how these five animal spirits affect economic decisions, demonstrating how they play a crucial role in answering eight questions:
- Why do economics fall into depression?
- Why do central bankers have power over the economy, insofar as they do?
- Why are there people who can't find a job?
- Why is there a trade off between inflation and unemployment in the long run?
- Why is saving for the future so arbitrary?
- Why are financial prices and corporate investments so volatile?
- Why do real estate markets go through cycles?
- Why does poverty persist for generations among disadvantaged minorities?
We see that animal spirits provide an easy answer to each of these questions.
We also see that, correspondingly, none of these questions can be answered if people are viewed as having only economic motivations which they pursue rationally- that is, if the economy is seen as operating according to the invisible hand of Adam Smith.
Each of these eight questions is fundamental. They would occur to anyone with a natural curiosity regarding the economy. In providing natural, satisfactory answers to all of them , our theory of animal spirits describes how the economy works.
In answering these questions, in telling how the the economy really works, we accomplish what existing economic theory has not. We provide a theory that explains fully and naturally how the U.S. economy and indeed the world economy , has fallen into the current crisis.
And-of perhaps even greater interest- such a theory then allows us to understand what needs to be done to extricate ourselves from the crisis."
" So many members of the macroeconomics and finance profession have gone so far in the directions of "rational expectations" and "efficient markets" that they fail to consider the most important dynamics underlying economic crises. Failing to incorporate animal spirits into the model can blind us to the real sources of trouble."
"The financial-markets egg has broken. If Humpty Dumpty had had the correct view of how the world works, he would not have fallen off the wall in the first place. Similarly if the purchasers of assets had realized how the economy really works, they would have been more careful in their purchase of assets, and the economy would not have taken a tumble. But even now, because of a false sense of how the world works, many policy analysts and especially, most of the public fail to see that Humpty Dumpty cannot be fixed and needs to be replaced."
" It is necessary to incorporate animal spirits into macroeconomic theory in order to know how the economy really works. In this respect the macroeconomics of the past thirty years has gone in the wrong direction. In their attempts to clean up macroeconomics and make it more scientific, the standard macroeconomics have imposed research structure and discipline by focusing on how the economy would behave if people had only economic motives and if they were also fully rational."
" Let's review the current U.S. economic cycle (we could do this as well for other countries) and see how the themes in this book have played themselves out. The role of animal spirits is central to our description.
The tale basically begins in 2000 and 2001. In 2000 there was a tremendous stock market crash, as the economy recoiled from the irrational exuberance of the dot-com years. The growth rate of real GDP decelerated from about 4% for 1999 and the first half of 2000 to only 0.8% for the first half of 2001. The Bush administration used the downturn to argue for massive, permanent tax cuts. The first and largest of these was signed into law in June 2001. The Fed also came into act. The discount rate , which had been 6% in the last half of 2000, was brought down to only 0.75% by November 2002. There is every reason to believe that both of these measures were effective. The previous boom had been top-heavy in expenditures on capital equipment. Investment in equipment and software had been especially high just prior to Y2K scare. In this new boom the stimulus came from housing. In the four short years from 2001 to 2005 expenditures on housing increased by 33.1% , while GDP growth was only 11.2%.
But then, as we had already recounted , odd things began to happen. These are the types of things that happen in booms as overconfidence takes hold. People began to buy housing as if this were their last chance ever to buy a house (because, they thought, prices would continue to escalate beyond their means), and speculators began to make investments in housing, as if other people were going to think that they should buy now, at almost any price, because they would not be able to afford to buy a house later. Home prices increased by almost two-thirds in the short span of time between the first quarter of 2000 and the first quarter of 2006. In Los Angeles, Miami, San Francisco and some other areas they increased considerably more. Vast areas of farmland were turned into new housing developments almost overnight. It was housing speculative fever.
Even more surprisingly, it was not just home buyers who engaged in this fever. The financial markets- which are supposed to be so cautious - aided and abetted the process. Of course the real estate dealers and mortgage brokers had no reason to dampen the fever. They were collecting transaction fees. And, with business so brisk, those fees were enormous. Most surprisingly, those on the other side of the ledger took in those mortgages and gave the home buyers the massive funds they needed for their unwise speculations.
We have recounted in a nutshell what has happened in the current financial crisis. It corresponds to our description of what causes most of our economic ups and downs:
over-confidence followed by under-confidence "
References:
George A. Akerlof & Robert J. Shiller (2009). Animal Spirits: Princeton University press
By
SK
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