Animal spirits and what else is wrong with neoclassical economics

A much discussed book this year has been Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George Akerlof and Robert Shiller. One of the best discussions is by John Gray in the London Review of Books. Link. He credits Akerlof and Shiller for their evisceration of neoclassical economics for assuming at its core rational behavior of human beings—conceiving them to be a species, homo economicus, that is not us. Gray goes beyond this and points out that even if we all were homo economicus, important parts of the future are always unknowable and cannot be quantified and factored into market decisions as probabilities. A third theme of the review is the hubris of the neoclassical school in assuming that the magic beans they had discovered would work in any environment and that, indeed, no other doctrine would lead to economic abundance. Unaccountably and regrettably, these ideologues appear not to have noticed in the real world the massive contradictions to that view. A few excerpts:

. . . . 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.'

. . . .

. . . . 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.

. . . . 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. . . .

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. . . . [I]n 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.

. . . .

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. . . .

. . . . 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.

. . . .

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.

. . . .

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.

Thanks to Mort for bringing this piece to my attention.

Update on Saturday, December 19, 2009 at 07:37AM by Skeptic

Gavin Kennedy reposted parts of this and added his comments on Adam Smith's Lost Legacy. (Scroll to November 26, 2009.) Kennedy is an economic historian and an expert on Adam Smith, about whom he has written extensively, including two books. 

Comments

[Clay Barham]

Seeds for the beanstalk were laid almost 400 years ago when about fifty people founded a settlement in New England and had no one to rely on but themselves, at which point individual freedom became a reality, which lead to a free market and a lot of prosperity found in one nation in the world. However, Lafayette told Tom Paine the same would never work in the rest of the world becasue tradition blocked it. Now, our new President says community interests are more important than are individual interests, which means the old tradition has come to swamp our own, as cited in claysamerica.com.