Customer Reviews

Animal Spirits: How Human Psychology Drives the Economy and Why it Matters for Global Capitalism

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Economists, in pursuit of mathematical precision, seem to have forgotten that not everything can be easily counted. Traditional economic theory centers on the premise that people make perfectly rational decisions. People, however, are not so rational. Despite many attempts, not every variable that goes into our decision-making process can be easily quantified, weighted, and stuffed into a formula. As any non-economist knows psychology -- and its hard to measure variables -- plays a large role in how people make decisions.

George Akerlof and Robert Shiller's book, Animal Spirits, offers an accessible look at how traditional economics can be expanded by incorporating some basic concepts from psychology. The term "animal spirits," originally coined John Maynard Keynes in the 1930's, describes how impulses and emotions naturally lead to economic boom and bust cycles. Traditional economists seem to have ignored even the most primitive of these spirits.

Economists create impressively complex formulas attempting to accurately describe the state of the economy and predict future trends. However, there are just too many unquantifiable variables - feelings, emotions, intuition, and confidence- to accurately incorporate all available information into a simple neat equation. Incorporating psychology into economics may not sound like much of a breakthrough. But Akerlof and Shiller have stepped outside of current economic thought to gently nudge animal spirits back to the discipline.

The first part of the book offers five examples of animal spirits: confidence; corruption; money illusion; stories; and fairness. While there are many more psychological factors at work in decisions, these offer a step in the right direction. A quick look at the internet bubble shows how these spirits can unknowingly influence our decisions.

In the late 1990's, investors were confident in a "new economy" and drove the price of internet related stocks up far more than a reasonable estimation of their economic prospects would justify. As the stock market increased in value, we entered a positive-feedback cycle from our investment decisions that further increased our confidence. As confidence rose so did the markets. In the end, we all know how this cycle turned out.

In the second part of the book Akerlof and Shiller answer some big questions calling attention to the role of the animal spirits. Why do economies fall into depression? Why is saving for the future so arbitrary? Why is there unemployment? Why are financial prices so volatile? Why do real estate markets go through cycles? Why is there special poverty amongst minorities?

The book offers persuasive, well-researched, prose that challenges the conventional wisdom that underlines much of existing economic theory. In attempting to answer some large fundamental economic questions by calling attention to psychological influences, the book offers a first glimpse of what economic solutions might look like in the future.

Given such accomplished economists, and being sympathetic to behavioral economics I expected better from this volume. The book has obviously been rushed to print. There are numerous errors. Just to give a few examples:

They present Adam Smith as the father of the rational economic man model when in fact he was the author of "The Theory of Moral Sentiments" (a masterwork of psychology) and certainly never claimed that emotions did not matter for economics.

They present Keynes as having "animal spirits" at the center of his theories which is not true. They do not even give the background to the phrase, which was more than two hundred years old at the time Keynes wrote.

They completely misrepresent the work of Milton Friedman generally and with respect to the Great Depression specifically. They even get his ideas about money illusion wrong. They seem hopelessly confused about the difference between Friedman and the later "rational expectations" theory. In fact there is surprisingly little about modern macroeconomics including modern Keynesian thought.

Did they even read Friedman's great work on the Monetary History of the United States? They make a single reference in passing to it in the text. It is extremely meticulous in tracking the events of the Great Depression. Even J.K. Galbraith highly praised it as a work of empirical research.

Although they discuss bubbles and speculation the general reader would finish the book with no idea that experimental economists have been replicating and studying these phenomena in the lab for over 20 years and have discovered many things about what contributes to them. This is part of the authors' pattern of setting up mainstream economics as a straw man with no concern for psychology.

A more fundamental flaw is that they never make a persuasive case that animal spirits are the core of the problem. Yes there are many historical anecdotes and stories - but there is no overall scheme or theory in this book. It's a mess of disconnected thoughts, stories, anecdotes etc..

On a final note, there is a degree of condescension to the general reader which is quite irritating. For example, in discussing poker in the introduction we are informed that players often try to deceive their opponents and this is called ... "bluffing." (!)

In summary, a book that was rushed to market.

"Animal Spirits" is an important contribution to rethinking economic theory, particularly macroeconomic theory, so that it better takes account of human irrationality.

The central argument of the book is that various human emotions - overconfidence, unwarranted pessimism, a sense of fairness, and stigma effects - can have important aggregate effects on the economy. Economists have often tended to overlook these factors, for several reasons: the irrational is difficult to model, and it has sometimes been assumed that these "irrationalities" will average out or be weeded out by the market. But Akerlof and Shiller argue that frequently such "animal spirits" can result in self-reinforcing cycles of either boom or bust. Irrationality is not only not tamed by the market, but can even be reinforced.

Akerlof and Shiller consider varied topics in this book, including determinants of savings rates and wages, and high African-American poverty. However, most of the book focuses on how "animal spirits" might help better explain the business cycle. Their book is opportune, as the current downturn is plausibly explained as the result of the excesses of an unregulated speculative fever in housing and related investments. Their book includes a valuable postscript to one of the chapters that analyzes possible responses to the current financial crisis.

I think this book is best suited to an audience that is reasonably well-aware of economic ideas about markets and the macroeconomy. This of course includes professional economists as well as many policy wonks interested in macroeconomic policy. It would also be a valuable corrective for a wider audience that holds the belief that the market is always in the aggregate efficient. This book supplies one more valuable argument for some government intervention in the market: the need for regulation to discourage various sorts of speculative bubbles.

Laced with examples and stories of how "Animal Spirits" impact our economy, this book is an enjoyable read. The authors' main point is that the study of economics, as taught in universities, focuses too much on just the numbers and graphs and dismisses the "thought patterns that animate people's ideas and feelings, their animal spirits." Chapters on confidence, fairness, corruption and bad faith make many good points about how impactful these are on the economy and how, overall, our emotions lead us to decisions that the numbers might not say are rational.

These are excellent points. However, the book doesn't quite do the job of pulling everything together as convincingly as it might. It goes overboard in many ways without substantiating its arguments. The authors say that they started writing the book in 2003, but it read more like it was thrown together and rushed out the door to sell in our current economic environment.

As a quick aside, the title might seem a little odd to someone not familiar with "Animal Spirits". The term comes from John Maynard Keynes, a well known economist from the 1930's, whose writings are the basis of Keynesian Economics. Many current economists base their viewpoints on Keynes' concepts, particularly when arguing for support of the stimulus package. In any case, in his famous 1936 book The General Theory of Employment, Interest and Money, he used the term "Animal Spirits" to describe the thought patterns mentioned above. Now the term "Animal Spirits" is widely used in economic circles when discussing emotion and its affect on human behavior.

One of the best chapters in the book is on Money Illusion. Money Illusion occurs when people don't take into account the real, or relative, value of things. Instead they only look at the nominal value when making their decisions. In plain English, this means that people forget about the impact of inflation when making purchasing, investment, salary or other decisions. . I see examples of this every day when talking to clients and colleagues. Akerlof and Shiller make the excellent point that since the 1960's the concept of Money Illusion was driven out of mainstream macroeconomic thought.

The authors don't support all of their arguments well and I don't agree with all of their arguments in this chapter. For example, they argue that, without Money Illusion, mortgages would all be indexed somehow to inflation; but they are ignoring one's need to have the certainty of fixed payments for planning. Since one cannot know how things will be adjusted in the future, they opt for a fixed payment stream. This does not necessarily imply that Money Illusion is involved in the decision (although it certainly may be in some cases). They take their argument too far here.

Page 173 spells out, in a fairly clear manner, the authors' political points of view. "Without intervention by the government the economy will suffer massive swings in employment. And financial markets will, from time to time, fall into chaos." I find this selection stunning in what it leaves out. Government involvement in the Great Depression clearly caused tremendous swings in employment and amazingly large moves in the financial markets. To say that government will prevent them strikes me as surprisingly naïve. I do believe we need to change how and what we regulate, but throughout the book the authors seem to suggest government involvement as the panacea.

Clearly, the capital markets need some rules and regulations under which to operate, and those areas with lax or no regulations (i.e. credit default swaps) contributed greatly to the economic position we're in. However, the book goes overboard in its recommendations of government regulation and control without sufficient support for its argument.

Apparently this book has been read by some of the top policy makers in the Obama administration. I hope that the issues the book raises with respect to "Animal Spirits" are reflected in their policy, while many of the solutions presented in the book are not.

Overall, this is a fairly easy and quick read, and although I'm rating it only 3 stars, I recommend it for the layperson with an interest in economics and in looking at some of the reasons for the situation in which the U.S. -- and the world -- find themselves. My caveat is that, should you choose to read the book, you are very careful in accepting the authors' solutions to solving our economic issues.

I am a retired engineer who worked on many problems of system dynamics. I am not knowledgeable about the field of economics as are most of the reviewers which I read. I was motivated to read "Animal Spirits" mostly because of my disgust at the Adam Smith-Milton Friedman blind adherence to the concept that "markets are self-correcting" and I wanted to read how two outstanding economists would show how human actions can destabilize the system. Alas, I was disappointed. The book is worth reading, but I did not find it an easy read. Partly, it was because of my unfamiliarity with the vocabulary of the economists, and partly because it droned on and on, saying the same things in different ways, which is so typical of these types of books. What shocked me, though, was that, although the authors spoke several times about "feedback," the word "stability," or variations thereof, did not occur once in the 176 pages. A function of several variables can be well-behaved over most of its range, but have singularities where the function goes to infinity. Conversely, a function may be mostly unstable, but have small ranges of stability. An analogy of the latter would be the classic example of the marble carefully balanced at the top of a convex surface. Any small disturbance which moves the marble, however imperceptibly, away from its balanced position causes it to depart ever more from that position. However, now consider that there is a small depression at the top of the convex surface. Within that small region, the system is stable and the marble will return to the center. Adam Smith prevails! As long as all is at or close to equilibrium, and there are minimum external disturbances, people behave in a rational manner and the system is self-correcting. But if there should be an input that pushes the marble past the depression, it will move ever away from the middle. When it has not gone too far, small corrective forces can stabilize the system. The actions by the Fed in adjusting credit and money supply were quite effective when the system was not too far from equilibrium, but when "irrational exuberance" took hold, the system became vulnerable to corruption or financial chicanery. An analogy for human reactions which drive the system to extremes, up or down, is the ouija board. Everyone puts their fingers lightly on the planchette to follow its movements as if caused by some supernatural force. Some little disturbance causes it to move and everyone follows, they think, but they are really pushing it in concert to the edge of the board. Akerlof and Shiller, following Keynes, call it "animal spirits." But it is just the natural herding tendency of many types of living things. Another good analogy for the economic system is the broomstick, which one can easily balance on a fingertip. When it is near balance, it is easy to control it with small motions of the hand (actions of the Fed). When it starts to fall, it takes violent corrective motions of the hand to catch it and restore balance (stimulus programs). If these fail, the broom falls to the ground -- the system collapses (The Great Dpression). It is unfortunate that Akerlof and Shiller did not pull their argument together at the end and make the point that animal spirits in their feedback effects act to destabilize the system. Some form of controller must be employed, whether by private or governmental action. See the article by Brian Hayes, "Everything is Under Control," in the May/June 2009, issue of American Scientist. Akerlof and Shiller make good points on multiplier effects, but never brought out the fact that credit is the multiplier for liquid cash and is an inherent part of the "plant," as the control-system designer calls it, the operating element of the economic system which converts materials and labor into useful outputs. Credit is the amplifier and, as everybody knows from squealing public-address systems, excessive amplification can cause instability. Excessive credit has been noted by many writers as one of the causes of current (June 1009) difficulties. Akerlof and Shiller seem to give up on the possibility of treating animal spirits in any quantitative way. I suggest that much could be done by further research on this topic. And, to add another engineering thought, to find ways to just slow down the pace of transactions in proportion to the magnitude of recent changes, a mechanism which would be the equivalent of adding damping to an oscillating system.

This book covers a number of important topics that are lacking from modern macroeconomic theory, and has come out at a time when interest in the problems with modern theory has reached a fervent pitch. Sadly though, the book is short, very unevenly written and clearly rushed to press in order to meet a new demand for answers as to why our economy is ruled less by logic than by the psychological complexities of individual people.

These criticisms are all the more interesting given that in their acknowledgments, the authors note that drafts of the book were used for the last 5 years as textbooks for a class at Yale. Surely there was enough interest in the psychology of markets, and time to finish the book, before the current crisis began.

Is the lesson to learn here that even economists who want to improve their field suffer from a laziness that permeates academia, and leads to such poor modeling to begin with?

I'm reluctant to criticize Yale's Robert Shiller, who has spoken highly of my own book "The Big Three in Economics," and who has an exceptional record in predicting the top of the stock market in 2000 and the real estate markets in 2006.

There are some good ideas and details in "Animal Spirits." For example, I didn't know that Enron abused the new "mark-to-market" rules established by the SEC to overbook profits (pp. 33-34).

But I was surprised by the large number of gaffes made in "Animal Spirits," such as:

1. The authors failure to include any reference to Milton Friedman and Anna Schwartz' classic "Monetary History of the United States" in explaining the cause of the Great Depression in the 1930s. They adopt an entirely outmoded Keynesian explanation, and make no reference to the collpase of the money stock during the early 1930s. As Friedman & Schwartz demonstrate, this monetary collapse was completely avoidable.

2. On page 130, Akerlof and Shiller claim, "In the absence of social security people would grossly undersave." Isn't it just the opposite? It is BECAUSE of social security that people grossly undersave, especially poor people who have no surplus left after shelling out 15% of their paychecks for FICA. In China, where there is no federal social security system, the Chinese people grossly oversave.

3. On page 173, Akerlof and Shiller state, "Without intervention by the government the economy will suffer massive swings in employment." Again, shouldn't it be just the opposite? It is BECAUSE of intevention by the government that the economy suffers massive swings in employment and output. The authors themselves point to numerous examples in their book where government caused instability in the marketplace, such as the SEC "mark to market" ruling that helped Enron overvalue its assets....and Andrew Cuomo, HUD Secretary under Clinton, who "mandated lending by Fannie and Freddie to underserved communities....Cuomo forced Fannie Mae and Freddie Mac to make loans, even if that meant lowering credit standards." (page 155) So who started the subprime lending scandal? The federal government (HUD and other agencies).

In short, I question the whole thesis of this book, that "left to their own devices, capitalist economies will pursue excess....manias and panics." (preface) I defy the authors to show me an example of capitalism going haywire without bad government playing a significant role in the background.

I was deeply disappointed by this book. I was truly surprised by the lack of any academic standards and lack of thoughtfulness. There are many ideas here but none are well thought out and they are not put together in a cohesive theory, nor is there any attempt to prove them using well available data. For instance: the authors seem to be stomped by peoples refusal to have their wages lowered during deflationary times and they suggest that this is due to the money illusion. However, is it not obvious that deflationary wages increase ones debt burden? They also seem to suggest that corruption is one of the causes of depression. Why not test this idea by looking at historical data on corruption (There is plenty available) and plot that against GDP growth? I was also surprised that leverage and debt were not once mentioned in the book, even though the book attempts to explain the origins of depression (Then meander off to other topics).
I do not recommend this book.

I bought this book in the hope that it would add something new to the many books on this topic I have read.

It was simply a rehash of other people's work, and then poor coverage of what it all means.

The book lacks any real academic grounding. Maybe I simply misunderstood this as a serious book on the topic rather than a populist book.

If you want a good coverage of how interactions drive economics, I strongly recommend The Origin of Wealth.

Economists are discussing the reasons for the last financial crisis, but they agree generally that economics as a science should be a case for revision. The audience is waiting for a decisive book by a new Adam Smith.

The candidate could be in the shape of the new book by George Akerlof and Robert Shiller. Akerlof himself was awarded the 2001 Nobel Prize and he is the main force behind the development of behavioral macroeconomics. Shiller is the main candidate for the next Nobel Prize as a man who foretold the present financial crisis a few years back. These two great names promised a great book. But I fear we are still waiting.

The expression "animal spirits" (spiritus animalis) refers to a basic mental energy and life force. In modern economics it refers to a restless and inconsistent element in the economy. John M. Keynes emphasized the importance of animal spirits in real economic activity, although it did not figure as a determining factor in his economic theory.

Akerlof and Shiller argue and repeat several times that Adam Smith ignored the animal spirits. In fact, Smith is not only the author of "The Wealth of Nations", where he argued that economic behavior was motivated by self-love, but as a professor of moral philosophy he was also the author of "The Theory of Moral Sentiments". According Smith, men, like all other animals are a part of nature. Smith's works were based on a very clear recognition of human psychology. His speculative merchants, butchers, brewers and bakers were real people with all their weaknesses and greed, as well as altruism. Adam Smith is the father of economics as a science. But economic man (homo economicus), as a rational creature motivated purely by economic interests is certainty not his child.

In fact Smith's actors are driven by an internal struggle between their impulsive, fickle and indispensable passions, and their conscience. They are multidimensional human beings. It is therefore high time to recognize him as a forerunner of behavioral economics.

Smith only used the phrase 'invisible hand' three times in all his works, including once in "The Theory of Moral Sentiments" (over 500 pages) and once in "The Wealth of Nations" (over 1000 pages). G.Ackerlof and R.Shiller have used 'invisible hand' four times in their 200 page book.

The Akerlof-Shiller case is only the tip of the 'invisible hand iceberg' developed over many decades by numerous authors. This kind of phenomenon is recognized and described very well by behavioral economics and is called `anchoring bias'.


Jan Polowczyk, Poznan, Poland