Akerlof and Shiller: "There was nothing rational, well ­informed or unemotional about the behavior that has all but collapsed the economy"

Look around you, George A. Akerlof and Robert J. Shiller say. The second coming of the Great Depression is, like the original, a direct result of animal spirits. If only we had factored those turbulent emotions into economic theory, we might not be repeating the earlier tragedy.

Akerlof, a Nobel laureate, and Shiller, a good bet to become one, are prominent mainstream economists. They don’t deviate easily from orthodox theory, with its allegiance to the proposition that people are essentially rational, well informed and unemotional in the numerous transactions that shape the economy. But in “Animal Spirits,” they have deviated — and they have done so just as mainstream theory self-destructs.

There was nothing rational, well ­informed or unemotional about the behavior that has all but collapsed the economy. That leaves most of America’s economists without a believable framework for explaining how we got into this mess. Akerlof and Shiller are the first to try to rework economic theory for our times. The effort itself makes their book a milestone.

Keynes performed a similar service in the 1930s — mainly by making the point that market economies could suffer long periods of high unemployment and low output unless government stepped in to supply the necessary demand. Barack Obama’s $787 billion stimulus program reflects his insight.

But another aspect of Keynes’s thinking did not fare well. He also introduced the world to “animal spirits,” coining that phrase to describe a range of emotions, human impulses, enthusiasms and misperceptions that drive economies — and ultimately unwind them. The economists who interpreted Keynes “rooted out almost all of the animal spirits — the noneconomic motives and irrational behaviors — that lay at the heart of his explanation for the Great Depression,” ­Akerlof and Shiller declare.

Addressing this wrong, the authors attempt to restore animal spirits to economic theory. They do this by drawing on the greater understanding of human psychology that exists today, and which Akerlof and Shiller, along with other economists, have incorporated into the relatively new field of behavioral economics.

Until now, behavioral economics has focused mainly on a variety of disparate traits that chip away at the assumption of rationality embedded in mainstream ­theory. A young person, for example, fails to join a 401(k) plan, even one subsidized by his employer, although if he were ra­tional and fully informed, he would certainly sign up.

What Akerlof and Shiller do is to highlight this sort of finding, packaging it with numerous other psychological insights into a half-dozen broad maxims that permanently alter the concept of rational behavior. And their book takes their case not just to economists, but also to the general reader. It is short (176 pages of text) and easy enough for laymen to understand (most of the time).

Above all, they challenge the reigning free-market ideology of the past 30 years or so, from the rise of Margaret Thatcher and Ronald Reagan to the abrupt arrival of the present crisis late last year. That ideology held that markets should operate free of government because they were rational. But if animal spirits influence behavior, then government must play a broad, disciplinary role, and do so permanently.

Akerlof and Shiller spent five years writing “Animal Spirits” and honing that conviction. They are concerned that once we enter a revival, pressure will inevitably build — just as it did in the late 1970s, more than a generation after the Great Depression — to give the markets free rein again. Akerlof and Shiller intend their book as an obstacle to that ever happening.

“The system of safeguards developed from the experience of the Great Depression has been eroded,” they write. “It is therefore necessary for us to renew our understanding of how capitalist economies — in which people have not only rational economic motives but also all kinds of animal spirits — really work.”

Both men are old hands at prodding their fellow economists into recognizing exceptions to mainstream theory. Akerlof, a professor at the University of California, Berkeley, shared a Nobel Prize in 2001 for his work on “asymmetric information,” which means that some parties to a transaction know more about the deal than others, like the used-car salesman who knows more about the shortcomings of the vehicle he is trying to sell than the customer he is pitching. Lemon laws, protecting consumers, grew out of such findings. Akerlof has long believed that in most market situations a government role can improve the outcome. “Animal Spirits” brings that view to a high boil.

Shiller, a Yale professor, originated the phrase “irrational exuberance” before Alan Greenspan made it famous, and in his research he has documented the rise and fall of home prices going back decades, to demonstrate that the latest surge was far and away the greatest in American history. The bubble will burst with very unpleasant results, Shiller warned, well before that actually happened.

What are these animal spirits that drive the American economy? Confidence is one. Far from dispassionately weighing and analyzing all the options, people act on the confidence, or overconfidence, that a home they are about to buy will be worth more a year later. Confidence drove up stock ­prices in the 1920s and again in this decade, far more than corporate balance sheets and pure reason would justify, and now lack of confidence, spreading like a contagious disease, is exacerbating the sell-off.

Fairness also shows up as an animal spirit, influencing thousands of decisions in ways that part company with standard theory. Out of a sense of fairness, for example, bosses often pay their employees more than the market demands. “Considerations of fairness are a major motivator in many economic decisions,” Akerlof and Shiller write, “and are related to our sense of confidence and our ability to work effectively together.”

Corruption, too, is an animal spirit. This includes the propensity to produce not just what people really need but what they think they need, like the mortgage-backed securities, “a modern form of snake oil,” the authors declare.

In their list of animal spirits, the two economists pay special attention to the tendency of people to think in terms of narratives or stories. “High confidence tends to be associated with inspirational stories, stories about new business initiatives, tales of how others are getting rich,” the authors write. On the other hand, ­stories about the Great Depression shape our narrative of what is happening now, and our behavior.

So what is to be done? Animal spirits are human emotions; they can’t be turned off. Unchecked, they drive the economy into misbegotten booms and disastrous busts. Tempered by government, on the other hand, they are a great source of entrepreneurial energy, safely channeled into a healthy capitalism. Keynes came to that conclusion, and Akerlof and Shiller, in “Animal Spirits,” push hard in the same direction — prodding their colleagues to follow their lead in revamping economic theory to deal with a market system that, quite irrationally, failed to govern itself.

(from NYT, April 17, 2009