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Animal Spirits Akerlof.Front 10/30/09 2:13 PM Page Ii Akerlof.Front 10/30/09 2:13 PM Page Iii Akerlof.front 10/30/09 2:13 PM Page i Animal Spirits Akerlof.front 10/30/09 2:13 PM Page ii Akerlof.front 10/30/09 2:13 PM Page iii Animal Spirits HOW HUMAN PSYCHOLOGY DRIVES THE ECONOMY, AND WHY IT MATTERS FOR GLOBAL CAPITALISM With a new preface by the authors GEORGE A. AKERLOF AND ROBERT J. SHILLER Princeton University Press • PRINCETON AND OXFORD Akerlof.front 10/30/09 2:13 PM Page iv George Akerlof is the Daniel E. Koshland Sr. Distinguished Professor of Economics at the University of California at Berkeley; co-director of the Program on Social In- teractions, Identity and Well-Being of the Canadian Institute for Advanced Re- search; and a member of the board of directors of the National Bureau of Economic Research. Robert Shiller is the Arthur M. Okun Professor of Economics at the Cowles Foundation for Research in Economics and Professor of Finance at the International Center for Finance, Yale University; research associate at the National Bureau of Economic Research; and co-founder and principal of two U.S. firms that are in the business of issuing securities: MacroMarkets LLC and Macro Financial LLC. The views expressed herein are solely those of the authors and do not necessarily reflect the views of these institutions. Copyright © 2009 Princeton University Press Requests for permission to reproduce material from this work should be sent to Permissions, Princeton University Press Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock, Oxfordshire OX20 1TW press.princeton.edu All Rights Reserved Ninth printing, and first paperback printing, with a new preface by the authors, 2010 Paperback ISBN: 978-0-691-14592-1 The Library of Congress has cataloged the cloth edition of this book as follows Akerlof, George A., 1940– Animal spirits : how human psychology drives the economy, and why it matters for global capitalism / George A. Akerlof and Robert J. Shiller. p. cm. ISBN 978-0-691-14233-3 (hardcover : alk. paper) 1. Economics—Psychological aspects. 2. Finance—Psychological aspects. 3. Capitalism. 4. Globalization. I. Shiller, Robert J. II. Title. HB74.P8A494 2009 330.12′2019—dc22 2008052649 British Library Cataloging-in-Publication Data is available This book has been composed in Adobe Galliard and Formata by Princeton Editorial Associates, Inc., Scottsdale, Arizona Printed on acid-free paper. ∞ Printed in the United States of America 10 9 Akerlof.front 11/2/09 9:08 AM Page v Contents Preface to the Paperback Edition vii Preface xxi Acknowledgments xxvii introduction 1 Part One: Animal Spirits one Confidence and Its Multipliers 11 two Fairness 19 three Corruption and Bad Faith 26 four Money Illusion 41 five Stories 51 Part Two: Eight Questions and Their Answers six Why Do Economies Fall into Depression? 59 seven Why Do Central Bankers Have Power over the Economy (Insofar as They Do)? 74 postscript to chapter seven The Current Financial Crisis: What Is to Be Done? 86 eight Why Are There People Who Cannot Find a Job? 97 nine Why Is There a Trade-off between Inflation and Unemployment in the Long Run? 107 ten Why Is Saving for the Future So Arbitrary? 116 eleven Why Are Financial Prices and Corporate Investments So Volatile? 131 twelve Why Do Real Estate Markets Go through Cycles? 149 thirteen Why Is There Special Poverty among Minorities? 157 fourteen Conclusion 167 Notes 177 References 199 Index 219 v Akerlof.front 10/30/09 2:13 PM Page vi This page intentionally left blank Akerlof.front 10/30/09 2:14 PM Page vii Preface to the Paperback Edition The worldwide recession that was raging just as the hardcover edition of this book was published in February 2009 seems to many observers, as of this writing in October 2009, to be coming to an abrupt end. There are definite signs of improvement. These observers could be right. Maybe this is just another recession that will eventually be forgotten among the annals of business-cycle history. But the theory that we lay out in this book gives us cause to worry that we may be in a sick economy over much of the world for years to come. Even the stirring success stories of the past decade or so in the developing world, notably China and India, may see their economic growth reduced to a disappointing level. We think this because we have an unusual view of the economy, a view that animal spirits, as we define them in the Introduction, drive al- most everything. Animal spirits are more than just confidence as meas- ured by confidence indicators. We argue that declining animal spirits are the principal reason for the recent severe economic crisis. And, despite the recent positive economic indicators, we see no clear indication that these spirits are yet revived. The news media are singularly lacking in any explanation for the re- cent resurgence of the world economy beyond the improvement in leading indicators, such as stock market prices and retail sales numbers. The reasons the leading indicators have improved remain mysterious. The stimulus packages put in place by most countries do not seem to have been big enough to be held responsible. By many popular ac- counts, the nascent recovery merely reflects a new willingness to spend all over the world, as if that is a primordial force of the economy that defies any further analysis. There seems, to a reader of these accounts, to be an unseen force propelling the economy, driving it into its periodic booms and busts. But this perception is nothing new. In his 1873 book Lombard Street, Walter Bagehot said that it seems that in an economic recovery busi- ness “leaps forward as if by magic”: Most people who begin to think of the subject are puzzled. Why should there be any great tides of industry, with large diffused profit by way of flow, and large diffused want of profit by way of ebb? The vii Akerlof.front 10/30/09 2:14 PM Page viii preface to the paperback edition main answer is hardly given distinctly in our common books of polit- ical economy. These books do not tell you what is the fund out of which large general profits are paid in good times, nor do they explain why that fund is not available for the same purpose in bad times.1 Indeed, people are still puzzled today, in late 2009, by the sudden improvement in our world economy. Textbooks of economics, while vastly improved since Bagehot’s day, still do not give much enlighten- ment about the ultimate drivers of the economy. They do not do so be- cause the understanding of the drivers must lie somewhat outside the traditional boundaries of economic research, in the realm of psychol- ogy (as even Bagehot suggested), which is an intellectual tradition alien to most economists. Macroeconomists have found it difficult to for- malize the concept of animal spirits on their own terms, and so they have largely neglected it. The recovery we have been seeing of late certainly defies the analy- sis of many economists who build structural econometric models and see the sudden recovery as the result of “error terms” or “residuals” or “innovations” in their equations. It defies the analysis of those econo- mists of the “real business cycle” persuasion, who are in the habit of thinking that all economic fluctuations are ultimately driven by exoge- nous changes in “technology” and “productivity,” but cannot point to a description of the cause of such a change right now. And of course, it defies those who build purely statistical time-series models that quan- tify past patterns in the data and calculate an optimal extrapolation of recent wiggles in the same data. Not only are we puzzled by the sudden turn toward recovery, we also do not clearly see the longer-term threat to the economy. The longer- term problem today remains that, after a terrible financial crash, the coherence of our animal spirits and our economic institutions is shat- tered. Humpty Dumpty is broken and cannot be put back together again. We need a new egg. We have to reinvent our capitalist economy, reestablish a genuine creative business spirit in people’s minds, and sup- port their attitudes via institutions that really work and satisfy their def- inition of justice. Instead, today we have, in their eyes, institutions “too big to fail,” which are on life support from the government and our cen- tral banks, operating as money-printing machines, and a general feeling that business is corrupt and that the government support these institu- tions receive has been arranged by evil lobbyists. We are facing the same viii Akerlof.front 10/30/09 2:14 PM Page ix preface to the paperback edition problem today that we faced in the later years of the Great Depression (described in Chapter 6)—business today is inhibited by uncertainty about the future, about the tolerance of an angry public, about a dis- affected labor force, and about what further government actions may be coming. The basic theme of this book is that animal spirits are the force that drives all of this, and that to understand animal spirits we have to use methodologies outside of traditional economics, leading us to other social sciences. We identified five psychological factors, in Chapters 1 through 5 of this book, that we thought were of particular importance. They are confidence, fairness, corruption and bad faith, money illusion, and sto- ries. Changes related to all of these factors are the ultimate reason for the boom that preceded the world economic crisis, for the crisis and re- cession in which we have been immersed, and for the apparent begin- nings of recovery.
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