Did “animal spirits” mess up the economy?

Could “animal spirits” explain the unpredictability of economies and the emergence of economic bubbles? Economists George A. Akerlof and Robert J. Shiller believe so, as they explain in their recent book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.

Their use of the term “animal spirits” does not derive from animism or from its cousin sociobiology, but from a statement by John Maynard Keynes in his 1973 book The General Theory of Employment, Interest and Money (pp. 161-2, boldface mine):

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 the result of animal spirits — a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

In an excerpt from their Animal Spirits book in The McKinsey Quarterly, Akerlof and Shiller describe these animal spirits as irrational forces that can cause volatile market fluctuations, often contrary to the rationality that should guide markets under classical economic thinking.

While acknowledging that markets are indeed influenced by people’s rational self-interested behavior, Akerlof and Shiller maintain that

they are also guided by noneconomic motives—“animal spirits”—which Adam Smith and his followers largely ignore. Sometimes people are irrational, wrong, shortsighted, or evil; sometimes they act for action’s sake; and sometimes they uphold noneconomic values like fairness, honor, or righteousness.

In the excerpt, they lay out five aspects of animal spirits that affect the economy:

  1. confidence and the feedback mechanisms that amplify disturbances
  2. the setting of wages and prices, which depend largely on attitudes about fairness
  3. the temptation toward corrupt and antisocial behavior
  4. the “money illusion,” or confusion between the nominal and real level of prices (so that people, for example, often miss the fact that conservative investments may be risky in times of inflation)
  5. the story of each person’s life and the lives of others—stories that in the aggregate, as a national or international story, play an important economic role

The authors believe a new regulatory regime is needed that takes into account the animal spirits that drive markets. New regulations could help prevent volatility and collapse of markets, as well as the need for crippling public bailouts.

But interestingly, they also highlight the need for a new “story” about the economy:

For decades, the dominant story about the economy maintained that all the fluctuations described previously had a rational basis. During the bubble years, the story also held that any risk arising from assets such as houses and subprime mortgages could be managed through complex financial devices like securitization and derivatives, which were largely unregulated.

Then the story changed. The new one suggested that all this complexity was just a novel way of selling snake oil. As the new story about Wall Street and its products took hold, the life drained out of financial markets. Housing prices sank, the demand for exotic products collapsed, and the credit crunch began.

Now, they stress, “there must be a new story about markets — a story that doesn’t always predict sunshine.” This story acknowledges “that animal spirits play a significant and largely destabilizing role.”

Although regulation takes place at the level of government, stories or narratives play out in the public forum and in the media — as well as in people’s own minds and their interactions with others. The need for a new story has implications about how people set personal goals and what they strive for in life.

AB — 20 April 2009

5-Euro cardboard solar cooker could drastically reduce wood fires

On April 9, 2009, Forum for the Future announced that it has awarded a $75,000 prize to Kyoto Energy for its Kyoto Box, a cardboard solar cooker designed for households in developing lands. The foil-lined cooker can be made for only 5 Euros and can boil water as a substitute for woodburning.

Wood fires are considered a major source of deforestation and pollution in developing lands, as well as a source of greenhouse gases. They also present a household fire hazard and a danger to families’ health due to smoke inhalation.

The Kyoto Box (photo below, courtesy of Einar Lyngar, shows Kyoto Energy founder Jon Bohmer with the box) received the $75,000 prize in Forum for the Future’s FT Climate Change Challenge, which aims to “raise the profile of green innovation and demonstrate that there are solutions and money can be made from them,” according to the organization. The prize is sponsored by HP and FT (Financial Times).

Jon Bohmer and Kyoto BoxFrom the Bubbleconomics perspective, innovations like this represent, on the one hand, examples of entrepreneurial opportunities offered in the context of the Big Bubble problem — the proposition that the world economy is in an unsustainably overinflated state.

On the other hand, such innovations represent personal solutions for individuals and families that are struggling to survive on the lower tiers of the world economy. The Kyoto Box, as an example, provides a low-cost way to obtain clean water for drinking, cooking, and cleaning. In a previous post, we also pointed to the EDAR, a low-cost shelter for the homeless — see “Does Bubbleconomics offer solutions, or is it all negative?

For more details about the Kyoto Box, see this illustration at Kyoto Energy’s web site. Kyoto Energy offers some other interesting products, such as the Kyoto Turbo, a smokeless biomass cooker; the Kyoto Bag, a water carrier that can double as a solar-powered shower; and Kyoto Flash, a solar-charged light with battery backup. The company is also doing considerable work with larger-scale solar energy. The company is based in Nairobi, Kenya.

AB — 10 April 2009

Would they really hack the planet to sustain economic growth?

President Obama’s science advisor John Holdren tells the Associated Press that he has brought up geoengineering as a possible alternative in the fight against climate change in discussions with Cabinet-level U.S. officials, as well as with heads of agencies such as NASA and the Environmental Protection Agency (see AP’s article “Obama looking at cooling air to fight warming“).

Although Holdren is not advocating geoengineering right now — he believes reducing greenhouse gases is the right solution to global warming — he is concerned that “temperatures should be kept from rising more than 3.6 degrees,” writes AP science writer Seth Borenstein.

This will require that “the U.S. and other industrial nations … begin permanent dramatic cuts in carbon dioxide pollution by 2015, with developing countries following suit within a decade.”

Holdren’s concern is that such efforts are “racing against three tipping points,” according to Borenstein:

Earth could be as close as six years away from the loss of Arctic summer sea ice, he said, and that has the potential of altering the climate in unforeseen ways. Other elements that could dramatically speed up climate change include the release of frozen methane from thawing permafrost in Siberia, and more and bigger wildfires worldwide.

Wikipedia’s entry on “Geoengineering” defines the concept broadly as “the idea of applying planetary engineering to Earth,” involving “the deliberate modification of Earth’s environment on a large scale to suit human needs and promote habitability.”

One example example of geoengineering, Holdren told AP, would be:

Shooting sulfur particles (like those produced by power plants and volcanoes, for example) into the upper atmosphere … “basically mimicking the effect of volcanoes in screening out the incoming sunlight.”

This approach might be used to “try to produce a cooling effect to offset the heating effect of carbon dioxide and other greenhouse gases,” Holdren says.

Go here to see an interesting illustration from the New York Times of some possible solution geoengineering solutions (if you think “solutions” is the right word).

One statement in the Wikipedia article particularly caught my attention — it cited one “body of opinion that supports geoengineering because it may avoid or delay the difficult and expensive transition to a low carbon economy.”

From the Bubbleconomics perspective, I would suggest that governmental and economic interests might choose the geoengineering route as an effort to keep the Big Bubble inflated. In other words, environmental damage might be treated, whether consciously or unconsciously, as the price that has to be paid to maintain the overall economic bubble.

AB — 9 April 2009

Do happy faces cause dumb investments?

Could an investor be prompted to make a more risky financial decision when exposed to positive, optimistic stimuli, such as a smile on the face of someone recommending or selling an investment?

That’s the implication of research by Julie L. Hall, a doctoral student in personality and social psychology in the Cognitive Science & Cognitive Neuroscience Program at the University of Michigan.

Hall and colleagues studied investment decisions made by 24 research subjects during a market simulation game. Some choices were high-risk and some were low-risk. Participants were shown pictures of happy, angry, or neutral faces before they carried out investment decison-making tasks.

Researchers also used fMRI (functional magnetic resonance imaging) during the tasks to see which areas of the brain “lit up” while participants were deciding which investments to follow.

Writing for New Scientist, Peter Aldhous describes how the game was set up (“Cheery Traders May Encourage Risk Taking,” April 7, 2009):

For every round of the game, the bond paid out $3. One of the stocks paid out $5 half of the time, while the other lost $5 at the same rate. At the start of the game, the players were told the rules but didn’t know which of the stocks was good and which was bad: that only emerged as the game unfolded. As with real-world investments, the good stock became bad at certain points during the game, and vice versa.

As Hall and colleagues anticipated, the positive stimuli caused increased activity in areas of the brain associated with anticipation of a reward and correlated with risky decision-making.

In introductory material to her March 23, 2009, presentation at the annual meeting of the Cognitive Neuroscience Society (“Put Your Money Where Your Heart Is: An fMRI Investigation of Affective Influences on Financial Investment Decisions,” Julie L. Hall, Richard Gonzalez, Oliver C. Schultheiss, Cognitive Neuroscience Society Annual Meeting Program 2009):

As predicted, participants showed greater NAcc activation and were more likely to make risky investment decisions after happy versus neutral face primes in both the subliminal and supraliminal presentation conditions. In addition, participants also showed greater anterior insula activation and made slightly less risky investment decisions after angry versus neutral face primes during supraliminal presentation conditions.

Hall concludes that

… facial expressions of emotion, even when they are not consciously perceived, can influence investment decisions and suggest that the inclusion of affect may lead to more accurate models of economic decision making, which better explain irrational financial behavior. They also suggest that affective states during pre-choice stages of the decision making process may alter the perception of benefits relative to costs, leading to changes in financial risk taking depending on whether the affective state is positive or negative.

Brian Knutson, a psychologist at Stanford University, has done similar research. He acknowledges, writes Aldhous, that “it is hard to determine the extent to which real financial markets are driven by similar emotional factors.”

However, Knutson has found that “the nucleus accumbens,” the brain area associated with risky investment decisions, “is activated when we are anticipating a reward.” For example, “showing men erotic pictures leads to similarly risky investment decisions.”

This fits with the Bubbleconomics proposition that infectious optimism contributes to economic bubbles and to the disastrous results.

Hall tells Adhous,

When risk-taking is a good thing, it’s good to be in a positive mood. When risk-taking is a bad thing, it’s not good.

AB — 7 April 2009

The “Tulip Mania” Economic Bubble: Source of a Myth?

One often-cited historical example of an economic bubble is the “Tulip Mania” phenomenon of the 1600s, famous especially for the problems it created in Holland. The story goes that in the 16th century, tulips were introduced to Europe from Turkey andover time  become the object of a speculative bubble that collapsed in 1637, ruining many people in the process.

The Wikipedia entry on Tulip mania says that “the modern discussion of tulip mania began with the book Extraordinary Popular Delusions and the Madness of Crowds, published in 1841 by the Scottish journalist Charles Mackay.”

The Wikipedia article calls McKay’s account “popular but flawed” and says that “since the 1980s economists have debunked many aspects of his account.” McKay’s account traces back to a 1797 book by Johann Beckmann, A History of Inventions, Discoveries, and Origins.

The article says that both Beckmann and McKay’s accounts are “primarily sourced to three anonymous pamphlets published in 1637 with an anti-speculative agenda.”

The chapter on “Tulipomania” from McKay’s Extraordinary Popular Delusions and the Madness of Crowds can be found at this link on the online text archive Project Gutenberg.

Speaking of the tulip bubble, McKay writes that:

In 1634, the rage among the Dutch to possess [tulip bulbs] was so great that the ordinary industry of the country was neglected, and the population, even to its lowest dregs, embarked in the tulip trade. As the mania increased, prices augmented, until, in the year 1635, many persons were known to invest a fortune of 100,000 florins [guilders] in the purchase of forty roots.

In modern terms, it’s a little hard to judge the extent of the bubble described here, but McKay does present a list of items and their values in florins that were supposedly exchanged for just one root of the rare Viceroy tulip species:

Two lasts of wheat — 448
Four lasts of rye — 558
Four fat oxen — 480
Eight fat swine — 240
Twelve fat sheep — 120
Two hogsheads of wine — 70
Four tuns of beer — 32
Two tuns of butter — 192
One thousand lbs. of cheese — 120
A complete bed — 100
A suit of clothes — 80
A silver drinking-cup — 60

Total: 2500 florins

Rampant speculation on the value of rare tulip species resulted in the establishment of formal markets for their sale, says McKay:

The tulip-jobbers speculated in the rise and fall of the tulip stocks, and made large profits by buying when prices fell, and selling out when they rose. Many individuals grew suddenly rich. A golden bait hung temptingly out before the people, and one after the other, they rushed to the tulip-marts, like flies around a honey-pot. Every one imagined that the passion for tulips would last for ever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them.

Speculation also took hold among the laity:

Nobles, citizens, farmers, mechanics, sea-men, footmen, maid-servants, even chimney-sweeps and old clothes-women, dabbled in tulips. People of all grades converted their property into cash, and invested it in flowers. Houses and lands were offered for sale at ruinously low prices, or assigned in payment of bargains made at the tulip-mart. Foreigners became smitten with the same frenzy, and money poured into Holland from all directions.

When the bubble finally collapsed in 1637, McKay writes, “prices fell, and never rose again. Confidence was destroyed, and a universal panic seized upon the dealers.”

In the light of recent revelations about the perverse compensation system in today’s financial services industry (see “Should banking execs get paid a lot?”), it’s interesting to note what McKay says about the way in which some speculators managed to walk away unscathed while many suffered ruin:

Hundreds who, a few months previously, had begun to doubt that there was such a thing as poverty in the land, suddenly found themselves the possessors of a few bulbs, which nobody would buy, even though they offered them at one quarter of the sums they had paid for them. The cry of distress resounded every where, and each man accused his neighbour. The few who had contrived to enrich themselves hid their wealth from the knowledge of their fellow-citizens, and invested it in the English or other funds. [Italics ours.] Many who, for a brief season, had emerged from the humbler walks of life, were cast back into their original obscurity. Substantial merchants were reduced almost to beggary, and many a representative of a noble line saw the fortunes of his house ruined beyond redemption.

As mentioned above, modern scholarship has revealed some deficiencies in the received version of the Tulip Mania case study. We will plan on taking a closer look at those criticisms in future posts.

AB — 2 April 2009