Animal Spirits | George A. Akerlof

Summary of: Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism
By: George A. Akerlof

Introduction

Venture into the intriguing realm of ‘Animal Spirits’ as we explore the ways in which human emotions and psychology govern our economic decisions. George A. Akerlof delves into the enormous yet often overlooked impact that irrational choices and non-economic motives have on the economy. Subverting the notion of rational self-interest, Akerlof demonstrates the influence of fairness, confidence, belief, and stories on economic performance. Expect to discover how market crashes, moral hazard, and even unemployment are driven by these powerful influences that conventional economic theories often neglect.

Emotions in Economic Decision Making

Economic performance is largely mental, with emotions playing a vital role in decision making. Previous economists have ignored the impact of irrational behavior in economic decisions, resulting in massive dislocation. Rational self-interest does not account for unemployment, as individuals do not always make rational choices in pursuit of their economic interests. John Maynard Keynes argues that investments such as building a mine or constructing an office building cannot be made through rational calculation alone, as it requires animal spirits. Overall, emotions and non-economic motives play a crucial role in economic decision making.

The Power of Confidence in Financial Decisions

The word “confidence” is often used in business literature, and it can mean different things to different people. Economists view confidence as a predictor of a prosperous future, but common usage emphasizes trust and belief. Jack Welch, former CEO of General Electric, favored gut instinct over analytical projections when making business decisions. The 2008 economic crisis illustrated how the absence of confidence paralyzed credit markets and undermined economic policies. Fairness plays a significant role in financial decisions, affecting perceptions of confidence and cooperation. People are willing to work against their rational self-interest to punish what they see as unfair, often leading to unemployment. While neoclassical economic theory disregards fairness, economic experiments show the impact of fairness on financial decisions. Confidence in financial decisions is not solely based on rational predictions – it comes and goes, influenced by various factors such as perceptions of fairness.

The Influence of Moral Values on Capitalism

Capitalism produces what people are willing to buy, including shoddy merchandise and illusory securities. The lack of moral values in the securities markets has been a significant contributor to recent economic crises. Corporate CEOs and fund managers ignore crooked accounting and inappropriate investments as long as people are willing to buy them. Crises happen when moral hazard undermines confidence. The 1980s savings and loan crisis and the Enron scandal resulted from risky investments and sly accounting practices. The subprime mortgage crisis occurred because lenders made loans to people who could not repay them, but sold the loans anyway. During securitization, rating, and sales, participants downplayed the real risks, eroding confidence and deepening recessions. The conventional economic theory lacks principles regarding ‘animal spirits,’ rendering crises unpredictable.

The Illusion of Money

In the book, “The Money Illusion,” Irving Fisher’s anecdote about a woman’s $50,000 bond portfolio remained unchanged despite inflation, reveals irrational money illusion as an animal spirit. Economists like Paul Samuelson believed that workers bargained for nominal wages, but Milton Friedman argued that workers were not subject to money illusion. While workers expect wage negotiations to protect them against inflation, debt covenants, wage contracts, and corporate financial statements often fail to include inflation adjustments. This creates a dilemma as people resist wage cuts when prices drop, even at the cost of their livelihood. Thus, money illusion does exist to some extent.

The Power of Stories

Stories are the backbone of the way people think and live. Literary critics have found that most stories follow a few simple patterns, essential to human beings. Strong marriages, political leaders and even stock market bubbles have all been shaped by the power of stories. However, conventional economists ignore the impact of stories and instead focus solely on quantitative facts. This summary suggests that perhaps stories themselves could be the pivotal fact in shaping our lives. By inspiring confidence and connecting with people, a strong narrative has the power to change the course of history.

The Two American Depressions

The book discusses the two severe depressions in the U.S, one in the 1890s, and the other in the 1930s. Both depressions had similar components: a pervasive money illusion, a collapse in confidence, and stories of corruption and unfairness. The 1890s depression saw the rise of William Jennings Bryan’s call for an expansionary and inflationary monetary policy, while the Great Depression had stories of market manipulation after the stock market crash in 1929. The book compares and contrasts the two events to show similar patterns that led to economic downfall.

Beyond Open Market Operations

The Role of Central Banks as Lenders of Last Resort

Central banks may not have as much power as we think. Their traditional role in managing the money supply limit their ability to respond to economic crises. An exclusive focus on open market operations overlooks the fact that people can satisfy their transaction needs in other ways. The real power of central banks lies in their ability to act as a lender of last resort during times of crisis. The U.S. Federal Reserve, for example, provided liquidity to prevent the failure of Bear Stearns. This power is crucial and often overshadowed by conventional thinking about central banks’ roles.

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