Arnold Kling  

Akerlof and Shiller Heart Higgs?

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Morning Commentary (Feeling An... CBO Stimulus Estimates...

George A. Akerlof and Robert J. Shiller do not come to praise mainstream macroeconomics.


Keynes' followers rooted out almost all of the animal spirits...that lay at the heart of his explanation for the Great Depression...They...minimized the intellectual distance between The General Theory and the standard classical economics of the day.

This is from the preface of their forthcoming book, Animal Spirits. The most surprising passage is on page 70:

Economic historian Robert Higgs concludes that in the United States, "Taken together, the many menacing New Deal measures, especially those from 1935 onward, gave businesspeople and investors good reason to fear that the market economy might not survive in anything like its traditional form and that even more drastic developments, perhaps even some kind of collectivist dictatorship, could not be ruled out entirely." Such worries drove business investment to very low levels and brought corporate plans for expansion to a standstill.

Otherwise, I would not count on the authors finding much common ground with Higgs. I will offer a Masonomist perspective on the book.

Keynes used the term "animal spirits" to describe the irrational motives of entrepreneurs, who make risky investments in an environment in which the probability distribution of returns cannot be known. Akerlof and Shiller (henceforth AS) use "animal spirits" as a broad term to describe any motivational force that leads people to deviate from pure rational calculation.

One important component of animal spirits is confidence. Trade among strangers and long-term investment require confidence. AS seem to believe (as do I) in a Minsky-esque model, in which investor sentiment goes from wariness to confidence to over-confidence. In the over-confident phase, bubbles emerge. When a bubble pops, people revert to wariness.

Another component of animal spirits in the AS formulation is what they call corruption and bad faith. On p. 26, they write,


But the bounty of capitalism has at least one downside. It does not automatically produce what people really need; it produces what they think they need, and are willing to pay for...if they are also willing to pay for snake oil, it will produce snake oil.

I would suggest substituting "representative democracy" for "capitalism" and "vote" for "pay" in the preceding passage.

In fact, for all of the eclecticism that Akerlof and Shiller demonstrate, they utterly fail to mention public choice theory. Instead, their model of government is the shockingly naive metaphor of a parent. In the preface, they write,


The proper role of the government, like the proper role of the advice-book parent, is to...give full rein to the creativity of capitalism. But it should also countervail the excesses that occur because of our animal spirits.

AS believe that government paternalism is justified. They point out that people are not equipped to choose investments wisely or to save the correct amount. I will grant that this is true. That means that people should outsource their decisions to those who are wiser. In fact, we tend to do that. Many people invest using mutual funds, for example. The question that AS need to answer is why people should be compelled to follow the financial advice of government officials. What makes government officials immune from overconfidence, corruption, and susceptibility to stories? In fact, if government officials are the repositories of investment wisdom, why are state and local pension funds in such dire straits? Why do we have a Medicare program that is unsustainable?

One element of animal spirits in the AS depiction is the creation of stories. On page 89, they say that the initial story that people told themselves about mortgage securities is that they were a superior form of risk management.


But then the story changed. The new story...suggested that securitization and exotic derivatives could be nothing more than a new way of selling snake oil.

If mortgage securitization is snake oil, then it was snake oil that was patented and marketed by the U.S. government. Government agencies and government-sponsored enterprises established the mortgage securities market.

Recall what I wrote in my essay on Masonomics:

The Chicago economist says, "Markets work. Use markets."

The MIT economist says, "Markets fail. Use government."

The Masonomist says, "Markets fail. Use markets."

In the end, AS have written a book that represents the MIT point of view against the Chicago point of view. They write as if a transfer of power from markets to government implies taking decisions away from imperfect individuals and giving the authority to an omniscient, benevolent agency. Masonomics, with its strong background in public choice theory, rejects the model of government as benevolent. And with our grounding in Hayek, we cannot regard government as omniscient.

I can agree with AS in terms of much of their description of financial crises and their consequences. I share their rejection of mainstream economics and the pure Chicago school. However, their utter failure to address the Masonomics alternative means that they have made no headway in persuading me of the value of their prescriptions.



COMMENTS (6 to date)
anon1111 writes:

"If mortgage securitization is snake oil, then it was snake oil that was patented and marketed by the U.S. government. Government agencies and government-sponsored enterprises established the mortgage securities market."

Correct me if I'm wrong, but GSEs invented and issued only simple pass-through MBSs, i.e., where the MBS was collateralized by the entire loan, including principal and interest in entirety. And the mortgages collateralizing these MBSs were standard prime loans. And, finally, these MBSs have done fairly well during the credit crisis and have held up in value (so far).

It was the Wall Street wizards who invented and issued all these MBSs and CDOs that chopped loans up into a million pieces, not just in terms of different tranches, but in terms of having MBSs that were collateralized solely by the interest-only payments of an interest only Alt-A, or payments from years 7 and 8 of a subprime 10/1 option ARM, etc. These were the assets that have gone toxic.

Moreover, my understanding is that it was the Wall Street wizards creating these fancy instruments that created the mortgage crisis. This wasn't a case of supply driving demand, i.e., mortgage lenders were originating all these loans and then looking for someone to buy them and Wall Street obliged. Rather, demand drove supply, i.e., because Wall Street needed these exotic mortgages to create all their fancy, complex MBSs (MBSs collateralized only by the IO payments of an IO Alt-A, etc), they created the demand which the lenders satisifed.

So, if I am correct, it is grossly oversimplified to imply GSEs were just as bad as the private institutions, and so government is as much to blame as Wall Street and liberals can't pin this on the private sector. No, if I am right, government was responsible and appropriately risk-averse in the MBSs it created and issued, only the private sector succombed to the madness of the crowds with respect to MBS issuances. (Now GSE purchases of toxic assets, that's another story.)

Niccolo writes:

Excellent post and I mostly agree, but I come to the same problem that I've had with a few of your posts concerning the contemporary problems in the financial economy, which is the Minsky approach.


Whereas I think it is fine to generalize that financiers may go from overly confident to very wary, I don't know if this is the end of the explanation. Why do financiers become overly-confident?

There's obviously a reason for them to become very wary - a crisis is that reason - but I've yet to see an explanation for being irrationally confident other than that one day they just wake up mad with all their money and ready to throw it at anything that walks. I don't find that a convincing explanation for heavy confidence and knowing how closely I'm looked at when I work to make sure I don't screw up my superior's reputation for letting the team slack for a quarter, I highly doubt that financials are different.

Philo writes:

"AS seem to believe (as do I) in a Minsky-esque model, in which investor sentiment goes from wariness to confidence to over-confidence. In the over-confident phase, bubbles emerge. When a bubble pops, people revert to wariness."

If there were anything to this, we wouldn't need *government* to correct for it: the incentives for *private investors* to act as contrarians would be overwhelming.

Grant writes:

To add to Niccolo's comment, are we sure the main cause is investors themselves becoming more risk-prone? What about new investors entering the scene? To what extent might bubble investing be a shift in capital allocation from the prudent to the imprudent, instead of the prudent becoming less so? It seems to me that selection processes are as important as anything else.

Anyone can become an investor. Those who do, do so because they believe they will profit off of it. As I've posted before, I believe that once a more realistic model of heterogeneous expectations is used, credit expansion necessarily allocates capital in an imprudent, short-term-oriented manner. Those who have borrowed, loaned and invested wisely in accordance with a rational economic outlook don't have much reason to take advantage of temporarily lower interest rates.

I don't think we should be asking who has access to capital, or what their risk-preference is. Did they suddenly start enjoying risk because of the side of the bed they woke up on? That is like saying the crisis happened due to "greed". I think what we should be asking is what heuristics govern capital allocation, and under what market conditions are incorrect heuristics selected?

Tracy W writes:

Why do financiers become overly-confident?

There's obviously a reason for them to become very wary - a crisis is that reason - but I've yet to see an explanation for being irrationally confident other than that one day they just wake up mad with all their money and ready to throw it at anything that walks.

Well the story I can tell is that we learn by feedback. A financier invests in a product that is risky. They don't know how risky it is - no one knows. We will assume though that this is a product that normally makes a 10% return, but 0.01% of the time blows up and loses you all the money you did make. The investor by good luck they get a positive return. So they invest again, with a bit more money this time. Again by good luck they get a positive return. So they invest again, with a bit more money again. After a bit, other people notice that the investor is making decent money, ask what the secret is, try it themselves, and makes more money. The positive feedback loop leads to over-confidence.

Basically, we have brains that are really bad at assessing probabilities. You can see this in other cases - for example people develop superstitions, eg if they do well on an exam with a red pencil, some people will believe that they need to use a red pencil from now on (this may be the opposite to over-confidence, under assessment of their own abilities versus the red pencil).

floccina writes:

Grant wrote:

To what extent might bubble investing be a shift in capital allocation from the prudent to the imprudent, instead of the prudent becoming less so?

I am glad to see that someone else sees it the way that I do. In fact today I see the economy trying to deliver stuff to risk averse cash horders and wise investors like Warren Buffett but the Government is fight them tooth and nail.

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