Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, by George A. Akerlof and Robert J. Shiller (Princeton University Press, 264 pp., $24.95)

In the midst of the recession, one industry is booming: books attempting to explain the economic crisis and how to get out of it. Most are ideologically driven, indicting free-market theory and trumpeting the end of laissez-faire. George Akerlof and Robert Shiller, longtime critics of deregulation and coauthors of the new Animal Spirits, stand out from this crowd for their considerable credentials. With two other economists, Akerlof won the 2001 Nobel Prize for his analysis of markets with asymmetric information. In his famous parable, “The Market for Lemons,” Akerlof explains how the market doesn’t work when a car dealer knows that he is selling a lemon but the buyer is ignorant of this fact. When state regulation doesn’t step in to correct this asymmetry, buyers get trounced by dishonest (but rationally self-serving) sellers; eventually, the market for used cars disappears. Shiller, an expert on real-estate markets, was among the few prophets who, years ago, denounced the speculative housing bubble and derided those who believed that real-estate prices could only go up and up. Shiller’s work has demonstrated that real estate’s ever-increasing prices were a historical myth and that real-estate investments, in the long run, were less rewarding than stocks.

In their new book, the authors suggest that the economic crisis constitutes an ideological catastrophe: until late 2008, both public policy and private behavior had long shared a blind faith in the free market, as if Adam Smith’s “invisible hand” really existed. This mind-set, identified with Reaganism and Thatcherism, had led to an unbridled deregulation of the markets, the authors maintain. Supposedly, such deregulation caused the financial crash. This analysis offers nothing new, but Akerlof and Shiller become slightly more creative when they propose an alternative rationale for the discrepancies between how the market is supposed to work and how it really does work: animal spirits—a Keynesian concept better described as simple human passions.

In classical market theory, supply and demand are always balanced by price adjustments. In reality, though, only the stock exchange follows this pure model. Elsewhere, human behavior interferes with price movements. Passions, trends and fads, information or lack of it, lobbies, politics, and ideas all influence the market: prices do not regulate themselves in a vacuum. Consider the labor market. In theory, when the demand for labor decreases, especially in a recession, wages should decline, too, responding to the lessened demand. But many would-be workers will not accept lower wages: they refuse jobs out of a sense of honor, and this “animal spirit” affects the labor market. The result is increased unemployment, which is a consequence not of market failure but of the passions that trump market forces.

Akerlof and Shiller declare a new era in which the field of behavioral economics, which studies cognitive and psychological factors to explain individual economic choices, will replace classic free-market theory. Taking it as a premise that economic actors do not act rationally, the state assumes the responsibility to direct their behavior.

This new paradigm is more dazzling than convincing, since the authors have created a free-market straw man. No free-market economist ever pretended that the market was perfect or exempt from the influence of human passions. Free marketers have always recognized the need for transparent information, even before Akerlof’s research. And what, if not human passion, drives innovation and entrepreneurship, which lie at the core of the free-market vision? One looks in vain for any reference to these forces in the book. Moreover, to pretend, as the authors do, that the U.S. economy has been unregulated since Ronald Reagan’s presidency is simply wrong—it remains heavily regulated. Since the 1980s, deregulation, to the extent it has occurred, has brought growth to the U.S. and to the rest of the world, which Shiller and Akerlof only briefly acknowledge when they nod to the “wonders of capitalism.”

What about the argument that deregulation caused the financial crisis? It’s more accurate to say that the existing regulations failed. Those regulations became irrational when the market went global and financial actors began outsmarting regulators. Akerlof and Shiller join those urging more regulation, but they don’t indicate what kind, or how it should be managed, or by whom. In their disappointing conclusion, they suggest that the government “set up committees and commissions” to design regulations that would tame the animal spirits.

Despite such sketchy proposals, Animal Spirits will likely be influential. Shiller and Akerlof rightly argue that economic decisions, collective and individual, are widely influenced by a dominant mind-set. Free markets, privatization, deregulation, and low taxes had characterized that mind-set for nearly 30 years. Now Akerlof and Shiller suggest an alternative theory that justifies greater state intervention into the economy. Regrettably, they do not acknowledge that regulation has costs, or that expecting the state to be less imperfect than the market seems dubious at best.


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