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Wednesday, November 18, 2009

We simply do not know!

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

Bill Totten


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