Animal Spirits, Review
Updated: Jul 1, 2020
Book reviewed by
Anushka Saraswat
Bachelors in Global Affairs (H), Jindal School of International Affairs
The book Animal Spirits is co-authored by George A. Akerlof and Robert J. Shiller. The book is based on Behavioural Economics and helps us understand how emotions and thoughts play a vital role in impacting major economic decisions.[1] The authors began writing the book in 2003 and it was published in 2009 to promote an increase in government intervention in America to battle the economic crisis of 2007-08. Akerlof is a Nobel prize-winning economist who is also a professor at the University of California at Berkeley. He is best known for his article ‘The Market for Lemons’. He belongs to the new Keynesian school of thought of Economics. Siller, who is also a Nobel prize winner teaches Economics at Yale University. He bagged the Nobel prize for his empirical analysis of asset prices. He has won many honours and awards for his contribution to Behavioural Economics.
The book explains how declining animal spirits are one of the major causes behind the recent tragic financial crisis of 2007-08. Despite the visible recent positive1 economic indicators, there seem to exist, no clear indications that these animal spirits are rejuvenated yet. The book explains how people are still puzzled about what drives the economy, and argues that the answer lies in psychology. Animal Spirit uses approaches and methodologies outside1 of traditional economics taking help from social sciences to understand key economic issues. It aims to identify 5 psychological factors namely; confidence, fairness, corruption and bad faith, money illusion and stories which help decide the major economic concerns. The book also emphasizes the government’s role in a capitalist society. The authors do not analyze financial1 market models but have a lot to say about economic policy to explain how capitalism works in the real world. They suggest approaches like a cat in the hat and call for microeconomic reforms in financial regulation, bankruptcy law and equity.
The authors believe that we can understand how economies work and prosper by understanding people’s thought patterns, their ideas and feelings which the authors call, the animal spirits. The authors also argue upon how Adam Smith’s theory of free unregulated capitalism fails to explain why the economy goes through a roller coaster ride and how government intervention is important. It explains our peculiar relationship with ambiguity1 and uncertainty and suggests how changing confidence, temptations1, envy, resentment and illusions about the stories related to the nature of the economy have far-reaching effects.
Critical Analysis of three chapters
The researcher has analysed three chapters from the book, ‘Animal Spirits’ which are titled ‘Why are there people who cannot find a job?’ (Chapter 8), ‘Why is there a trade-off between Inflation and Unemployment in the Long Run’ (Chapter 9), ‘Why is saving for the future so Arbitrary’ (Chapter 10). The analyses are as follows:
The first chapter in the analysis talks about how human demand1 for fairness helps us understand unemployment and how economic policy1 should be carefully framed so that a situation of a high level of unemployment does not recur in the future. The author explains the Efficiency wage theory and how the efficiency of labour depends on the wage employees are paid.[2] The wage is set a little higher than what the worker will accept to keep him motivated. This creates an excess of supply of labour while the demand is less thus creating1 a gap which results in unemployment. The authors also explain how goods are different from labour as goods have no emotions and thus they do not always sell at the lowest possible price. The authors go on to analyse John Dunlop’s study on wages which elucidated on how workers at the same skill do receive different wages.[3] This happens primarily due to working conditions. When unemployment is high people don’t quit their jobs. We get to understand how unemployment is caused by wages over the market clearing. Through a study of Shapiro and Stieglitz’s theory of unemployment[4], the authors assert that firms cannot fully monitor the employees which create a situation of Work or Shirk. They also suggest that if there is no unemployment and wages remain the same, there would be equilibrium in unemployment. Extra wages provide labour with the incentive to work. If all firms pay extra wages, there will be unemployment. Seniority rights give an alternative incentive to extra wages. Wages are not only an incentive but a symbol of recognition and respect for the employee’s work. The wage expectation of an employee1 increases with a decrease in unemployment and with an abundance in better opportunities. This viewpoint of unemployment is more1 complex as it ascribes1 to an employee’s motives that are more realistic than a theoretical economic model and explains why quits go up when unemployment falls.
The second chapter in the analysis explains how the interaction between money illusion and fairness makes a difference. The authors put forward and contradict Friedman’s theory of how a sustainable level of unemployment at a natural rate would neither lead to accelerating inflation, nor a decelerating deflation. Employment should be increased only until its cost in terms of added inflation balances out the benefits. Analysis of the Phillips curve shows how inflation rises to very high levels only at very low rates of unemployment and thus employment could be permanently high. Friedman proved how unemployment lower than the natural rate does not yield steady inflation. Instead, it causes accelerating inflation and unemployment above the natural rate causes accelerating deflation. Explains how money illusion affects unemployment and inflation. A prime example of money illusion is how people believe wage cuts are unfair and thus wages are downwardly rigid. Wage cuts might reduce an employee’s commitment and motivation as they might see it as unfair. This would also make workers more likely to quit due to resentment. Natural rate theory has major shortcomings in the long run due to the assumption that long term price stability can be achieved with an almost negligible rise in inflation with no other ill consequences. Natural rate theory rests on the philosophical argument that people do not have money illusion but the hypothesis can be easily countered using the example of money wage stickiness. The authors explain how the people’s perception of an increase in their wages does not match with their concern about the rising rate of inflation and they can only be satisfied if the wages constantly increase and manage to keep up with the surging rate of inflation. The authors suggest how wage bargains only come into play at higher levels of inflation and are not much visible when inflation is low. He explains how people tend to think that their employer should make a wage adjustment when inflation becomes higher than usual to promote fairness. The natural rate theory is easily contradicted by the ideas of wage setting and price setting due to money illusion and fairness.[5] The author validates his claims using the example of Canada when John Crow, a staunch believer of the natural rate theory became the governor of Bank of Canada. He elucidates on how Crow was successful in curbing inflation from 4.8 per cent to 1.8 per cent but at a very heavy cost. Canada saw the worst levels of unemployment since the Great Depression at 11.3%. The author suggests that the natural rate theory should only be suggestive and should not be strictly abided by to avoid severe consequences of a similar manner.
The third chapter talks about how saving for the future is arbitrary. Animal Spirits play a large role in determining the level of saving amongst individuals. The author explains how the level of savings creates a huge impact on the economy of a country. An exponential increase in the desire of saving among people may have major consequences and may even tilt the economy towards a recession, which happened to be the case in the 2008 financial crisis. The same desire, in the long run, may result in the accumulation of a large amount of wealth. Thus the growth prospects and economic fluctuations can be understood by studying the impact of animal spirits on the level of saving. The author also talks about how saving and investing are the most common ways to become rich for an individual. He elucidates on the power of compound interests and how it can be utilised to amass wealth over some time. The social experiment conducted by the authors reveals that it is difficult to gauge and balance the benefits of current versus future spending and as a result, most people fail to comprehend how much they should save for the future. This phenomenon can be easily linked to the animal spirits of trust, confidence, fears and apprehensions as well as the stories people witness around them. The authors suggest how the psychological framing of an individual creates a huge impact on his level of savings as the levels differ drastically across various countries and economies. The authors explain how people find it hard to contemplate whether they should save that extra dollar or consume it and how the framing of one’s thoughts and the stories around them help in shaping this decision. The chapter entails various statistical surveys and experiments to give support to this argument and they tend to prove their point satisfactorily. The author also studies the wealth disparities among nations in this particular chapter and it is interesting to find how there exists a 1000 fold difference in per capita income between the richest and the poorest of the nations. He elucidates upon the various factors necessary to generate wealth such as geographical location, population, skills of the workforce, trade restrictions etc which impact the per capita income in a country. The author also sheds light upon the credit card culture prevalent in America which hampers the saving rate to a great extent.[6] At last, the author elaborates on how the savings of individuals may have a large impact on a country’s growth and progress and determine if they would have a happy retirement or a poverty-stricken lifestyle. The author is quite successful in proving how animal spirits drive this arbitrariness in saving levels and are thus critical in shaping a nation’s policies on saving.
References :
[1] Louis Uchitelle, 2009, “Irrational Exuberance”, New York Times, May 10, 2020. https://www.nytimes.com/2009/04/19/books/review/Uchitelle-t.html
[2]Mark Lim, 2018, “Efficiency Wage Theory”, Economics Help, May 10, 2020. https://www.economicshelp.org/blog/glossary/efficiency-wage-theory/
[3] MH Dobb, 2010, “Wage Determination under Trade Unions by Dunlop”, The Economic Journal, 411-414, May 11, 2020.
[4] Shapiro, Stiglitz, 1984, “Equilibrium Unemployment”, The American Economic Review Journal, 433-444, May 11, 2020.
[5] David Schmidt, 2015, “The natural rate of Employment”, The Economist, May 9, 2020, https://www.economist.com/schools-brief/2017/08/26/the-natural-rate-of-unemployment
[6]Mathew Fischer, 2009, “Rethinking the credit culture”, New York Times, May 11, 2020. https://www.nytimes.com/2007/10/26/business/worldbusiness/26iht-wbcredit.1.8065690.html