Human behavior defies the experts

Published 8:53 am Saturday, September 5, 2009

People are not always remembered for their achievements. Sometimes they are remembered for other people’s achievements.

Karl Marx, for example, was a gifted and perceptive analyst of capitalism and the forces that drove it. He will be most remembered, though, as the inspiration for a series of totalitarian states run by murderous thugs.

John Maynard Keynes, also, was a deeply thoughtful economist whose insights were based not just on brilliant analysis but years of practical and successful experience in financial markets. He will be most remembered, though, as the inspiration for a series of trillion-dollar federal budget deficits.

Keynes in particular is regaining his currency value in the conversations and writings of economists these days, not so much for his theory of why deficit spending — AKA economic stimulus — was necessary but for his thoughts on why economic theory wasn’t enough to explain some types of market trends and activities.

When George Ackerlof and Robert Shiller were looking for a title for their new book, published earlier this year, they eventually selected what was probably the perfect one for a new reality in economics — “Animal Spirits.”

“Animal Spirits” is a term that was used by Keynes to explain the unexplainable and unpredictable — the ups and downs and violent swings in markets that result from changing expectations. The full paragraph, as Keynes wrote it in 1936, is worth reading:

“Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

It is not an “easy read” by today’s standards. And its length would give newspaper editors and most book editors an advanced form of heartburn. Still, as with many of the economic thinkers of the past, Keynes packed a lot of ideas into his sentences. In fact, in these 101 words he managed to sum up the key issues that financial and other markets present to economic theorists and securities analysts alike.

Keynes’ experience as a player in the financial markets of his day — and the 1920s and 1930s were no stranger to market fluctuations — was telling him that people do not make their financial decisions, or any decisions, totally on the basis of math, statistics, logic or other rational process. They make them based on their instinctive reaction to information, including the stories they hear.

The problem for economists and economic theory is that if Keynes is correct about that, then there are parts of their economic models that are missing, and parts that might never really be known — and the models then will always fail just when you need them the most.

As an alternative Ackerlof and Shiller, in their new book, attempt to take Keynes’ idea of animal spirits and see if it could be examined and analyzed somehow to make an orderly science out of it … making predictions again possible and in that way restoring the credibility of economic theory.

Their effort is commendable, and the book is a worthwhile addition to the body of thought and knowledge on economics and markets. A good bit of this is attributable to the fact that both Ackerlof and Shiller work with mathematics and with the reality of markets and are comfortable with the practical as well as the theoretical sides. Ackerlof won a Nobel Prize for his work on how the information gap favors sellers in markets. And Shiller is not only a Yale professor but also co-developed the Case-Shiller Index, widely used today to track and understand real estate market movements.

The twin disciplines of reality and mathematics kept Ackerlof and Shiller from drifting into the unkempt speculations of what is now called “behavioral economics.” Instead, they provide us with a map of where we need to go to make macroeconomics a true predictive science. This is of crucial importance in today’s globally interconnected markets, for, as we now know, a crisis in confidence on Wall Street can spread instantly not only to Main Streets in the U.S. but also to cities, towns and villages all over the world.

Incorporating individual and group behavior into an economic policy model will not be an easy journey, despite the map provided by Ackerlof and Shiller. But we have to do it. It’s that kind of world now.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.