Irrational Exuberance Writ Large

George Akerlof and Robert Shiller on how psychological factors led to the bust and may impede a turnaround

Editor's Rating:

The Good: A look at the psychological factors behind the current mess—and suggestions for how to fix it.

The Bad: Not all of the book's parts mesh—and some sweeping claims aren't justified.

The Bottom Line: A bold and innovative work

Animal Spirits:How Human Psychology Drives the Economy,and Why It Matters for Global CapitalismBy George A. Akerlof and Robert J. ShillerPrinceton; 230 pp.; $24.95

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism is a book with a blue ribbon pedigree. It was written by two of the top economists in the world, George A. Akerlof of the University of California at Berkeley and Robert J. Shiller of Yale University. Akerlof won the Nobel prize in Economics in 2001; Shiller is famous for his research into stock and housing prices as well as for having predicted both the tech bust and the housing crisis.

The two superstars have produced a truly innovative and bold work that attempts to show how psychological factors explain the origins of the current mess and offer clues for possible solutions. At a time when plummeting confidence is dragging down the market and the economy, the authors' focus on the psychological aspect of economics is incredibly important.

The book, which the authors started writing more than five years ago, seems bolted together out of parts that don't necessarily mesh. It includes some sweeping claims that are not well supported, as well as chapters on topics—such as minority poverty—that are interesting but don't really belong. In some ways, Animal Spirits feels like a beta version of a breakthrough computer program: promising and a potential big winner, but not polished.

Their main thesis is simple. Akerlof and Shiller argue that conventional macroeconomics is wedded to the idea that people and businesses are rational actors. But this model falters during booms and busts. Instead, the authors say, the only way to understand today's crisis is to focus on noneconomic motivations and irrational behavior, or what they call "animal spirits."

That term was first popularized in the 1930s by John Maynard Keynes, who used it to refer to the optimism and confidence that allow business owners to invest for the future. Akerlof and Shiller's definition of animal spirits is much broader. It includes "confidence, fairness, corruption and antisocial behavior" as well as "stories," or the natural inclination of people to put together tales about the way the world works. If this seems like a broad collection of phenomena, well, it is.


Key economic developments, including booms and busts, are driven by shifts in animal spirits, say the authors. It is not uncommon, they suggest, for massive financial frauds—such as Bernard Madoff's alleged Ponzi scheme—to help fuel booms. Later, the discovery of the frauds helps to undermine trust and propel a bust. In the authors' words: "The business cycle is connected to fluctuations in personal commitment to principles of good behavior and to fluctuations in predatory activity."

Another example of animal spirits, say Akerlof and Shiller, is the willingness of people to believe in stories "that purport to describe historic changes that will propel the economy into a brand-new era." These "new-era stories" help fuel unsustainable booms because they encourage investors, consumers, and businesses to cast aside prudence and reckon that it's different this time.

The authors make powerful claims about the strength of their analysis. "We provide a theory that explains fully and naturally how the U.S. economy, and indeed the world economy, has fallen into the current crisis," they declare. But the pair have little to say about technology, while globalization, a key trend of recent years, does not appear in the index.

The omission is disturbing: It is difficult to believe that a world economy with near-instantaneous communications, and including a mix of Western and Asian cultures, is driven by the same psychological factors as those that held sway during the last great U.S. boom and bust, in the 1920s and '30s—a period the authors look to often.

Indeed, one alternative to the Akerlof-Shiller theory is that, prior to the recent meltdown, investors, consumers, and businesses simply made a mistake when faced with the complexities of globalization and technological change.

Animal Spirits is filled with provocative ideas, some of which are not fully developed. Early in the book, Akerlof and Shiller put forth the notion of a "confidence multiplier." In their view, just as government spending can have a wide-ranging impact on growth—the so-called fiscal multiplier—government actions to boost confidence can have an impact that far exceeds the original effort. But after introducing the concept, the authors do little with it. When they offer solutions for the current crisis in the postscript to chapter 7, the term doesn't appear. Instead, they advise policymakers to aggressively push credit into the economy, as the Fed and Treasury have already been doing. These actions are necessary, they say, to take the place of parts of the financial system handicapped by negative animal spirits. Perhaps, but it leaves open the issue of whether government can directly boost confidence.

The authors' overarching message is that government needs to act forcefully to tame animal spirits, almost like enforcing rules on a child. In fact, they think government should follow the model in parenting books that advise being neither too authoritarian nor too permissive. Given the depth of today's downturn, such a prescription may find a highly receptive audience.

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