A downturn in imaginative thinking

A new book claims that people’s psychology and ‘animal spirits’ bring about economic downturns. It’s an argument that is both economically vulgar and politically unconvincing.

Stuart Derbyshire

Topics Books

The central thesis of George Akerlof and Robert Shiller’s Animal Spirits is that we ‘will never really understand important economic events unless we confront the fact that their causes are largely mental in nature’. Akerlof and Shiller claim that economic events, including the current crisis, are driven by psychological errors or the mobilisation of ‘animal spirits’. The problematic animal spirits are confidence, corruption, money illusion and storytelling.

Confidence and corruption are both problematic because they drive up asset values irrationally. Over-confidence leads to expectations that markets will only go up, so the value of stocks or housing are expected to continue in a positive direction and a bubble develops. A lack of confidence, in contrast, leads to overselling and a collapse in market values.

Corruption creates bubbles and collapses in a more straightforward manner. Akerlof and Shiller cite the case of Enron where executives pursued increasingly imaginative accounting practices that eventually became fraudulent. One of the early imaginative strategies was to book expected future profits as current – so called mark-to-market accounting – and thus inflate current profitability. This, entirely legal, strategy encouraged further imaginative strategies such as systematically underestimating the cost of projects and overestimating the returns.

A particularly egregious example was a promised gas-fired electrical generation system intended for Dabhol, India. The project was booked and the profits recorded as current, but then the project became impossible to deliver at reasonable cost. Regardless, Enron accountants continued to book enormous profits from a project that was delivering massive losses. As it began to unravel Enron turned to directly fraudulent activity involving creating dummy corporations to buy up Enron assets at inflated prices. Enron eventually collapsed, leaving thousands of employees without work and with worthless Enron stock supporting their pensions.

Although Akerlof and Shiller go some way towards explaining how confidence and corruption inflate and deflate value, they largely fail to explain why confidence changes and corruption appears. They merely argue that these things are ‘irrational’. Undoubtedly there is some irrationality in expecting that stock values and house prices can only increase, and traders investing heavily on margin and consumers taking out loans against inflated house valuations compound that irrationality. But there is nothing irrational in expecting that an economy will, in general, continue to grow. A universal expectation that useful and necessary things will be created in less time as technology and society progress is not unreasonable. When that is not delivered, it is an indictment of how production is organised, and not a reason to condemn investors and consumers as irrational.

The tendency to blame people for the failure of economies to deliver is well illustrated by Akerlof and Shiller’s explanation of ‘money illusion’. Money illusion is the tendency to believe that the value of money does not change, so that £10 today is the same as £10 last year and the same as £10 next year. Simplistically, money illusion is the tendency to ignore the effects of inflation or deflation. According to Akerlof and Shiller, the failure to recognise that the value of money fluctuates leads workers to resist wage reductions in times of deflation. They explain that the 1930s Great Depression came about in part because of workers refusing nominal pay cuts and thus pricing themselves out of the labour market and causing unemployment.

The idea that nearly a quarter of the American population were unemployed in 1933 because of an irrational tendency to demand a steady wage level is fanciful at best. And it is difficult to accept that unemployment in Newcastle, England, where shipbuilding fell by 90 per cent, hit 70 per cent because of money illusion.

Finally, Akerlof and Shiller argue that we maintain some irrational behaviours because of the stories we tell. For example, workers expect fairness from their employers and employers want to be seen as good, and these expectations or stories combine to keep wages at a higher level than necessary. Black Americans lock themselves out of the job market because of the story they tell about we and they, and the story of exploitation at the hands of a system that they did not choose and that they consider unfair.

In 1929 the first edition of Henryk Grossman’s Law of Accumulation and Breakdown of the Capitalist System appeared in German. Grossman was critical of those who tried to find psychological reasons for the economic crisis then engulfing the world:

‘Economists like JB Clark (1907) and Alfred Marshall (1890) imagine that the psychological and individual motivations driving capitalists to “save” account for the entire problem of the accumulation of capital. They do not bother to ask if there are objective conditions that determine the scope, the tempo and finally the maximal limits of the accumulation of capital.’

Grossman goes on to explain that it is a general law of progress for the means of production [M] to supplant labour expenditure [L] and release people from the need to work. Capitalist expansion is based on the valorisation of capital (c) and labour value (v) to produce a surplus (profit). It follows that capitalism can only secure the expansion of M relative to L if the constant growth of c + v can secure a profit. Grossman correctly asks if a process of this sort is sustainable and his conclusion is that it is not. Consequently, he reaches very different conclusions from today’s theorists about the causes of unemployment:

‘Workers become redundant not because they are displaced by machinery, but because, at a specific level of the accumulation of capital, profits become too small and consequently it does not pay to purchase new machinery and so on.’

It is not that society no longer wants the products produced by capital and workers are too attached to nominal wages for production and employment to continue. It is the internal workings of capital that prevents production and fails to provide work. The economy today is different from 1929, but the difference lies in the structure of capitalism not in the psychology of individuals. Today we are facing a financial crisis in the West exacerbated by a massive reduction in real production creating a large and growing imbalance between East and West. The recycling of money to create more money was bound to fail regardless of the influence of confidence, corruption, money illusion or storytelling. The tensions unleashed by these structural faults require analysis and collective action; our individual behaviours in the face of these faults are not very important, though the collective will and vision of the ruling elites – or rather the absence of it – are clearly important factors in how and whether the recession might be resolved.

Akerlof and Shiller provide an account of the economic crisis that fails to account for the actual workings of the economy and instead blames bankers and workers for the crisis. That makes their account degenerate economically, but it is also politically problematic. Not only have we given up on examining the workings of capital to provide real explanations for the crisis; we have also seemingly given up on the general law of progress described by Grossman. Rather than believing that human society should advance through producing more stuff in less time, there is a palpable suspicion that we are already producing too much stuff too quickly. Expecting growth is condemned as problematic, an irrational belief connected to confidence and corruption. Growth in any economy, however, is dependent on a belief that growth is a fundamentally good thing and the basis of all human freedom. That psychological belief really does matter for global capitalism, but, sadly, Akerlof and Shiller fail to mention it.

Stuart Derbyshire is a senior lecturer in psychology at the University of Birmingham. He will be speaking in the debate Nudge Nudge, Nag Nag: the New Politics of Behaviour at the Battle of Ideas festival on Sunday 1 November at the Royal College of Art in London.

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, by George A Akerlof and Robert J Schiller, is published by Princeton University Press. (Buy this book from Amazon(UK).)

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Topics Books


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