Animal Spirits : An interview with Bob Shiller - From McKinsey Quarterly
From Animal Spirits
For years, the world economy has been on a roller coaster. Yet not until it began to veer off the tracks did the passengers realize that they had embarked on a wild ride. Abetted by their thoughtlessness, the amusement park’s management didn’t set limits on how high they could go or even provide safety equipment.
Why didn’t people recognize the warning signs until banks collapsed, jobs vanished, and millions of mortgages were foreclosed? The answer is simple. Textbook economics teaches the benefits—and only the benefits—of free markets. This belief system, which has flourished throughout the world, holds that capitalism is essentially stable and has little need for government interference. According to that line of reasoning, which dates back to Adam Smith, if people in free markets rationally pursue their own economic interests, they will exhaust all mutually beneficial opportunities to produce and exchange.
Even at the theory’s worst, it deserves high marks, at least by the criterion of a schoolboy we overheard in a restaurant who was complaining about the C he had received on a spelling test, though 70 percent of his answers were correct. In fact, however, we believe that Adam Smith was basically right about the economic advantages of capitalism. But we also think that his theory fails to explain why the economy takes roller-coaster rides, and the takeaway message—that there is little need for government intervention—is simply wrong.
Adam Smith saw that human beings rationally pursue their economic interests, and his economic theories explain what happens when they do. But they are also guided by noneconomic motives—“animal spirits”—which Adam Smith and his followers largely ignore. Sometimes people are irrational, wrong, shortsighted, or evil; sometimes they act for action’s sake; and sometimes they uphold noneconomic values like fairness, honor, or righteousness. As the economist John Maynard Keynes understood, “Our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing.” In such an uncertain world, many decisions “can only be taken as a result of animal spirits.”1
Five aspects of these animal spirits affect the economy: confidence and the feedback mechanisms that amplify disturbances; the setting of wages and prices, which depend largely on attitudes about fairness; the temptation toward corrupt and antisocial behavior; the “money illusion,” or confusion between the nominal and real level of prices (so that people, for example, often miss the fact that conservative investments may be risky in times of inflation); and the story of each person’s life and the lives of others—stories that in the aggregate, as a national or international story, play an important economic role.
The current crisis stems from our changing level of confidence, from temptations, envy, resentment, illusions, and, especially, from changing stories about the economy—stories that first glorified financial “innovation” and then represented it as a con game. These intangibles explain why people paid small fortunes for houses in cornfields; why others financed those purchases; why the Dow Jones industrial average peaked above 14,000 and fell, little more than a year later, below 7,000; why the US unemployment rate rose by 4 percentage points in 24 months; why Bear Stearns was only (and barely) saved by a Federal Reserve bailout and Lehman Brothers collapsed; why many banks are underfunded; and why some totter on the brink, even after a bailout, and may yet vanish.
Animal spirits at play
Explanations that involve only small deviations from Adam Smith’s system of pure economic rationality are clear because they are posed within a very well-understood framework. But this doesn’t mean that small deviations describe how the economy really works. Economic theory should be derived not from them but from the large, observable deviations that actually occur. A description of how the economy really works must consider animal spirits.
Why are financial prices so volatile?
No one has ever made rational sense of the wild gyrations in financial prices—gyrations as old as financial markets themselves. The US stock market’s real value rose over fivefold between 1920 and 1929 and then came all the way back down from 1929 to 1932. It doubled between 1954 and 1973 but fell by half from 1973 to 1974. It rose almost eightfold between 1982 and 2000 and then fell by half from 2000 to 2008. No one can explain these fluctuations rationally, even after the fact. Economists can sometimes justify the stock price changes of individual companies, but not aggregate stock price movements, which don’t seem explicable by changes in interest rates, dividends, earnings, or anything else.
When the stock market tanks, the authorities try to restore public confidence by insisting that “the fundamentals of the economy remain strong.” The authorities are right in the sense that, almost always, it is the stock market that has changed; the fundamentals haven’t. How do we know that they couldn’t generate these changes? If prices reflect fundamentals, they do so because those fundamentals are useful in forecasting future stock payoffs. In theory, stock prices predict the discounted value of future income streams: dividends or earnings. But stock prices are much more variable than the discounted streams of dividends or earnings they are supposed to predict.
A person who claims that stock prices reflect information about future payoffs resembles a berserk weather forecaster in a town where temperatures are fairly stable. The forecaster predicts that on one day the temperature will be 150° F and on another day –100° F. Even if he has the mean right, he should be fired. Likewise, you should reject the notion that stock prices reflect predictions, based on economic fundamentals, about future earnings. Prices are much too variable.
Price changes do, however, seem to be correlated with social changes. The economists Andrei Shleifer and Sendhil Mullainathan have observed this phenomenon in Merrill Lynch advertisements. In the early 1990s, before the stock market bubble, Merrill ran advertisements showing a grandfather fishing with his grandson. The caption said: “Maybe you should plan to grow rich slowly.” When the market peaked, around 2000, Merrill’s dramatically changed ads showed a picture of a bull-shaped computer chip, with a caption that read: “Be Wired . . . Be Bullish.” After the collapse, Merrill went back to the grandfather and grandson fishing. The caption advertised “Income for a lifetime.”
Keynes compared the stock market to a competition that asks the contestants to pick the six prettiest faces from a hundred photographs. The prize goes to the person whose choices come closest to the whole group’s average preferences. Of course, to win such a competition you shouldn’t pick the faces you find prettiest. You should pick those you think others will find prettiest or, better yet, the faces you think that others will think that others will find prettiest. Investing in stocks often resembles that.
Red Delicious apples offer another metaphor. Hardly anyone really likes their taste, yet they have become, overwhelmingly, the best-selling apples in the United States. They tasted better in the 19th century, when a different apple was marketed under this name. As connoisseurs shifted to other varietals, growers, to salvage their profits, moved the Red Delicious apple into a new market niche. It became the inexpensive apple that people thought other people liked or that people thought other people thought other people liked. Most growers gave up on good flavor. Most Americans don’t understand that an apple could be so debased.2 Likewise with speculative investments: many people don’t understand how much a company can change or how many ways it can be debased. Stocks that nobody believes in but keep their value are the Red Delicious apples of investment.
Bubbles and the confidence multiplier
Obviously, investors want to get rich quickly when the market soars and to protect themselves when it sags. If they buy or sell in reaction to stock price increases or decreases, that response can feed back into additional price changes in the same direction—a price-to-price feedback. A vicious circle may prolong the cycle for a while. Eventually, the bubble bursts, since only expectations of further increases support it.
Price-to-price feedback may not suffice to create major asset price bubbles, but other forms of feedback—in particular, those between bubble-inflated asset prices and the real economy—reinforce it. This additional feedback increases the cycle’s length and amplifies price-to-price effects. There are at least three sources of feedback from asset markets to the real economy. When stock and housing prices rise, people who own these assets have less reason to save. Feeling wealthier, they spend more. They may also count their stock market gains or housing appreciation in current savings.
Asset values also play an important role in determining investment levels. When the stock market falls, companies spend less on new factories and equipment. When the market for single-family homes falls, construction companies drop plans to build. Bankruptcies too can greatly influence investments in business and housing. When asset prices fall, debtors default, compromising the financial institutions that normally provide debt financing. When they become less willing to make loans, the price of the assets drops more. Such asset price movements feed into public confidence: the price-to-earnings-to-price feedback. By contrast, rising stock prices boost confidence. People buy more goods and services, so corporate profits go up and stock prices rise again. These mutually reinforcing positive feedbacks continue for a while, until the feedback—and the economy—head in the opposite direction.
Leverage feedback and the leverage cycle intensify other kinds of feedback. The collateral ratio is the amount lenders extend to investors as a percentage of the value of the assets posted as collateral. On the cycle’s upswing, collateral ratios rise: for example, in the market for single-family homes, the amount banks lend to buyers (as a fraction of their homes’ value) goes up. Rising leverage feeds back into asset price increases, encouraging still more leverage. As asset prices fall, the process works in reverse.
The leverage cycle operates in part because of bank capital requirements. As asset prices rise, the capital of leveraged financial institutions rises relative to their regulatory requirements, so they may buy more assets. If many do, they may bid prices up, freeing more capital. A feedback loop thus propels prices steadily higher. If asset prices fall, leveraged financial institutions may have to meet their capital requirements by selling. The systemic effect may be still-lower asset prices, which decrease capital ratios, so the institutions must sell yet more assets. In extreme cases, downward feedback pushes prices to fire sale levels.
For most people, the rise in real earnings that accompanies a stock market boom proves that the boom is rational. Few see that the earnings rise may be a temporary manifestation of the stock market rise. If rents go up during a housing-price boom, people think the increase justifies the boom. They don’t consider the possibility that rising rents are a temporary manifestation of it.
Animal spirits and oil price movements
The price of oil too has fluctuated greatly—especially during the oil crisis years, 1973 to 1986. The first such crisis lasted from 1972 to 1974, when the Organization of Petroleum Exporting Countries (OPEC) restricted production. The price of crude oil more than doubled.
Ostensibly, OPEC was avenging the Arab defeat in the 1973 Yom Kippur War. But there is another, less well-known explanation. Before 1973, the anachronistically named Texas Railroad Commission regulated the fraction of time Texas oil producers could pump. These restrictions raised the price of oil. Little notice was taken in late 1972, when the quota rose to 100 percent. From then on, OPEC could restrict output to push up prices, and the United States couldn’t increase output in response, since it was already as high as possible. In 1979, the Iran–Iraq War disrupted the supply of Persian Gulf oil, and prices doubled again, remaining high until 1986. Then, following the recession of the early 1980s, oil prices fell by half.
This summary seems to suggest that fundamentals—if not economic fundamentals, then political and military ones—determine oil prices. Indeed, these probably were the dominant factors then and ever since. Even so, feedbacks among confidence, production, and prices in the oil market strikingly resemble those in the stock market.
A crescendo of rhetoric about the population explosion and the shortages it would engender accompanied the rise of oil prices in the 1970s. Just 18 months before OPEC restricted production, The Limits to Growth: A Report for the Club of Rome’s Project on the Predicament of Mankind3 foretold worldwide economic disaster—in one scenario, the death of as much as half of the world’s population late in the 21st century. Such thinking encouraged OPEC, whose ministers reasoned that reducing oil production would not only lead to higher prices but also save the remaining oil for a day when prices would be higher still. Of course, OPEC’s decision also confirmed the beliefs of those who concurred with the Club of Rome, a global think tank. What more dramatic proof could there be than a tripling of the price of oil? When the price fell in the wake of the recession of the early 1980s, the doomsday stories abated. A ProQuest search of the New York Times, the Los Angeles Times, and the Washington Post for articles containing the words “proven reserves” and “oil” yields 115 results from 1975 to 1979, 137 from 1980 to 1984—and only 73 from 1985 to 1989.
Resources are indeed limited. Global warming is a threat. But the price of oil and the stories about it resembled those about the stock market. Oil prices are variable. Again, the weather forecaster should be fired.
The markets as drivers of investment
A country’s investment in new machinery and equipment, factories, bridges and highways, software, and communications infrastructure matters enormously for its economic prosperity. Careful studies have confirmed that such investments raise the standard of living.
Nonetheless, executives make them in the face of fundamental uncertainty. Theoretical economists who struggle to understand how people handle uncertainty seem to be converging on behavioral economics. Jack: Straight from the Gut, the title of the autobiography of former GE chairman Jack Welch, sums up this reality: investment decisions are intuitive, not analytical. Intuition, a social process, follows the laws of psychology—indeed, of social psychology. Asking why capital expenditure fluctuates from year to year is a bit like asking why beer consumption fluctuates from one poker party to another.
Given the speculative fluctuations in asset prices, variations in investment levels must partly reflect beliefs about these changing prices. As Welch writes, “The company’s mood fluctuated on the bullishness of our press clippings and the price of our stock. Every positive story seemed to make the organization perk up. Every downbeat article gave the whimpering cynics hope.”4 To be sure, there is some doubt about the relation between stock prices and investment. According to a metric devised by the economists James Tobin and William Brainard, the correlation should be exact. In reality, it is weak.
The correlation holds for the crash years (1929 to the early 1930s) and for the millennium boom in the 1990s, when the market and investment rose and fell together. But there were two significant episodes when the stock market declined while investment continued robustly. After World War II, the market tanked, yet the economy became so strong that inflation rose above 14 percent in 1947; investment was also high. A similar scenario unfolded after the first oil crisis. The data seem to imply that if the stock market falls because of inflation while the economy remains strong, investment probably will too.
Taming the beast: Making financial markets work for us
For decades, the dominant story about the economy maintained that all the fluctuations described previously had a rational basis. During the bubble years, the story also held that any risk arising from assets such as houses and subprime mortgages could be managed through complex financial devices like securitization and derivatives, which were largely unregulated. Then the story changed. The new one suggested that all this complexity was just a novel way of selling snake oil. As the new story about Wall Street and its products took hold, the life drained out of financial markets. Housing prices sank, the demand for exotic products collapsed, and the credit crunch began.
So once again, capitalism’s dark side must be addressed. In the 1930s, in the wake of a huge catastrophe, the Roosevelt administration set up safeguards to protect the public from the excesses of free enterprise. For more than 70 years, those safeguards worked, but then complexity provided a way to evade regulation. Now there must be a new story about markets—a story that doesn’t always predict sunshine. New financial regulations will be needed to acknowledge the animal spirits that often drive markets, to make markets work effectively, and to minimize the possibility that they will collapse and require vast bailouts at public expense.
The present troubles aren’t really a crisis of capitalism. Free enterprise is still the best way to supply most goods and services. But financial goods and services are different. Capitalism works well when people know and understand what they buy. Most people, however, know almost nothing about the financial products purchased on their behalf—for example, through pension funds, 401(k) accounts, money market funds, or, if they are very rich, hedge funds.
If we thought that human beings were totally rational and acted mainly from economic motives, we, like Adam Smith and his followers today, would believe that governments should play little role in regulating financial markets and perhaps even in determining aggregate demand. But on the contrary, we believe that animal spirits play a significant and largely destabilizing role. Without government intervention, employment levels will at times swing massively, financial markets will fall into chaos, scoundrels will flourish, and huge numbers of people will live in misery. The right answers may not always be clear. But our country has no chance of finding them if it doesn’t acknowledge the importance of animal spirits.
About the Authors
George A. Akerlof is the Koshland Professor of Economics at the University of California, Berkeley. He was awarded the 2001 Nobel Prize in economics. Robert J. Shiller is the New York Times bestselling author of Irrational Exuberance and The Subprime Solution. He is also the Arthur M. Okun Professor of Economics at Yale University and is a Fellow at the Yale International Center for Finance, Yale School of Management. This article is adapted from their new book, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (Princeton University Press, 2009).
1 John Maynard Keynes, The General Theory of Employment, Interest and Money, New York: Macmillan, 1973 , pp. 149–50, 161–2.
2 Adrian Higgins, “Why the Red Delicious no longer is,” Washington Post, August 5, 2005.
3 Donella H. Meadows, Dennis L. Meadows, Jorgen Randers, and William W. Behrens III, The Limits to Growth: A Report for the Club of Rome’s Project on the Predicament of Mankind, New York: Universe Books, 1973.
4 Jack Welch with John A. Byrne, Jack: Straight from the Gut, New York: Warner, 2001, p. 172.