The economy's animal spirits

John Maynard Keynes first recognised it when seeking to explain why the Great Depression happened even though the economic theory of the time said it couldn't. But it's taken the global financial crisis to help us rediscover that truth: the main reason economies fluctuate as they do is the changing psychology of the people who compose the economy.

Keynes called this our "animal spirits", which is the title of a book by George Akerlof, a Nobel laureate in economics, and Robert Shiller, a leading proponent of behavioural finance.

Why isn't Keynes widely recognised for what he was: the first behavioural economist? Because his followers - notably Sir John Hicks, another Englishman - quickly suppressed that part of Keynes's explanation for the Depression in their efforts to make Keynesian thinking more acceptable to economists steeped in the neo-classical assumption that economic actors (you and me) always act rationally (with carefully calculated self-interest) and never emotionally or instinctively.

Hicks and others preferred to explain the Depression by means of the newly invented Keynesian "multiplier" so they could do what they thought mattered most, win support for Keynes's key policy prescription: the use of government spending to stimulate demand when it was deficient.

These days, the term animal spirits is usually used to refer to business and consumer "confidence", as measured by, for example, the Westpac-Melbourne Institute index of consumer sentiment and the NAB survey of business confidence.

But Akerlof and Shiller point out that "animal" means "of the mind" or "animating". So they take the term to refer to all our non-economic, non-rational emotions and motivations. Their point is that though these motivations have been defined as non-economic (and thus have been excluded from the conventional, neo-classical model of the economy), that doesn't stop them having a considerable influence over our economic behaviour.

The truth is that, even with a multiplier built in, the neo-classical model can't explain why market economies have always moved in cycles of boom and bust. It simply assumes the economy is always at full employment. But the changing moods and attitudes of the humans who make up the economy can explain the business cycle.

Akerlof and Shiller acknowledge confidence as the cornerstone of animal spirits, but argue they have four other components: fairness, corruption and bad faith, money illusion and stories. These other elements are needed to adequately explain the economy's ups and downs, and catastrophic events such as the global financial crisis.

Conventional economics assumes that when businesses or individuals make significant investment decisions they consider all the options available to them and all the possible monetary outcomes, they attach probabilities to each outcome, multiply the two together and then add them up to get the "expected benefit". If it's high enough, they go ahead with the project.

But often the probabilities are no more than educated guesses. So whether the project goes ahead often depends on how confident people feel about the prospects for the economy and their project, whether they're in an optimistic or pessimistic mood.

Concerns about fairness are excluded from the conventional model, but not from the motivations of economic actors. Questionnaires show most people regard it as unfair for a business to raise the price of umbrellas on a wet day (a behaviour economists regard as rational), but fair for it to raise prices when its costs have increased.

Sociologists tell us there are behavioural "norms" that describe how people think they and others should behave in particular circumstances. We get angry when people fail to conform to norms and this anger may have adverse consequences for businesses.

One area where perceptions of fairness are very much to the fore is in the setting of wages. Workers get angry when there's any suggestion of their wages being cut (even though they may well accept a fall in their real wages if economic conditions seem to warrant it).

Employers' inability to cut nominal wages when there's a fall in the demand for their product means downturns in the economy lead to more unemployment than they would if wages and prices were more flexible (as the model assumes).

Most recessions involve corporate corruption scandals and instances of "bad faith" (people behaving in ways that are unethical but not illegal).

The business cycle is connected to fluctuations in personal commitment to principles of good behaviour and to fluctuations in predatory activity, which in turn is related to changes in opportunities for such activity.

"Money illusion" means people base their economic decisions on "nominal" monetary amounts, failing to allow for the effect of inflation. But one of the most important assumptions of modern economics (where "modern" means it has reverted to the neo-classical assumptions that prevailed before the Keynesian revolution) is that people always see through the "veil" of inflation and compare prices in real terms.

The obvious truth is that sometimes people allow for inflation and sometimes they don't. Or, they do to an extent, but not completely. If so, this causes them to behave in ways contrary to those predicted by the conventional model.

The human mind is built to think in terms of narratives, of sequences of events with an internal logic and dynamic that appear as a unified whole. And much human motivation comes from living through a story of our lives that we tell ourselves.

The same is true for confidence in a nation, a company or an institution. Great leaders are first and foremost creators of stories.

High confidence tends to be associated with inspirational stories, stories about new business initiatives, tales of how others are getting rich.

"New era" stories (such as that the internet has brought us to a new era of profit and prosperity) have tended to accompany the major booms in sharemarkets around the world.

So ends Akerlof and Shiller's list of all the main "non-economic" things that are in our minds and that influence our economic behaviour, but aren't in the conventional model.

"If we thought that people were totally rational, and that they acted almost entirely out of economic motives, we too would believe that government should play little role in the regulation of financial markets, and perhaps even in determining the level of aggregate demand," they say.

"But, on the contrary, all of those animal spirits tend to drive the economy sometimes one way and sometimes another. Without intervention by the government the economy will suffer massive swings in employment.

"And financial markets will, from time to time, fall into chaos."