Thursday, July 02, 2009

"Animal Spirits" or Government Failure: Which Causes Economic Panic?

Those who subscribe to the economic theories of John Maynard Keynes believe that it is the "animal spirits" that reside in people that cause economic manias and panics. They're partly right. Classical economists believe that government mismanagement causes them. They're right, too. It's not hard to figure out which one is the most right, though. Too bad the Keynesians still cling to their disproven theories and ignore the inconvenient facts that have disproved them.

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In their book Animal Spirits: Why Human Psychology Drives the Economy and Why It Matters for Global Capitalism, authors George Akerlof and Robert Shiller resurrect an interesting concept that was first observed by John Maynard Keynes--that people have "animal spirits" that cause them to act in abnormal, non-economic ways.

The concept of animal spirits is a valuable contribution to the understanding of economics, because people sometimes do not act rationally. Although they may often act in ways that

Akerlof and Shiller's Animal Spirits makes an important contribution to the economic debate. Unfortunately, they spend the entirety of the book's 176 pages avoiding the fact that central banks have consistently been the fuel that have turned the flames of mass mania and panic into bonfires of destruction.

resemble "an invisible hand" that works toward the mutual benefit of society, as Adam Smith observed, sometimes they do not. Classical economists don't seem to take these episodes of irrational behavior into account as often as they should.

"People are not always rational in pursuit of their economic interests," say Akerlof and Shiller. That is a true statement.

"In Keynes' view," the authors say, "these animal spirits are the main cause why the economy fluctuates as it does." Oops! That is, inconveniently to Akerlof, Shiller, and all other Keynesians, a demonstrably false statement.

In his book, Meltdown, Thomas Woods, Jr. points out that manias and panics don't just happen on their own.
...describing something as a "mania" is no explanation at all, and that only expansionary monetary policy by the central bank can account for these phenomena:

If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset. The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it's so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses.

In order for a mania-driven boom to persist, there would have to be an increasing supply of credit to fund it.
Akerlof and Shiller's Animal Spirits makes an important contribution to the economic debate. Unfortunately, they spend the entirety of the book's 176 pages avoiding the fact that central banks have consistently been the fuel that have turned the flames of mass mania and panic into bonfires of economic destruction.

Yes, people do have animal spirits. But only government can give license to the collective animal spirit to such an extent that manias can turn into economic bubbles and subsequent full-fledged panics. The economic meltdown of 2008-09 is only the latest evidence of that.

Keynesian economics is not a complete waste of time. But it's important to understand that his theories have their certain limits.



4 comments:

  1. A recent study of behaviors of mall shoppers found that even when the vast majority (on the order of 80%) behave in economically irrational ways, the overall result closely approximates what would be considered ideal distribution if 100% of them had acted rationally.

    However, each of us acts within the boundaries of certain systems. If actors are capable of manipulating the incentives in the systems, irrational behavior is amplified so that distribution outcomes become skewed.

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  2. I recently had a discussion with someone who said the stimulus must have worked because Keynes says it should have.

    On another note, short of a central bank doing it, how would your perfect world set interest rates?

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  3. Don't Keynesians usually accuse Christians of blind obedience? ;-)

    My world doesn't even have to be perfect in order to achieve a much better way to set interest rates. If the central bank were gone, banks would set the rates that they could afford to offer. If they set the rates too low, they'll have too many people seeking loans for which the bank doesn't have enough funds. The Fed, on the other hand (just like every other central bank the United States has ever had) nearly always sets the rates too low, which signals to the markets that there is more credit than really exists in a healthy economy. In this very imperfect scenario, if banks don't peg their rates closely to the Fed's rates, they will be out of business.

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  4. I think you may be defining the problem too narrowly. Booms and busts did not begin with central banking. They are caused by the difference between what I call the "Real Interest Rate" and the interest rate which is set when Fractional Reserve Banking rules are applied.

    Fractional Reserve Banking allows the creation of fictional money (that it is fictional is revealed during a 'run' on the banks). This fictional money is loaned out at a lower rate than the "Real Interest Rate" because of its greater supply and lower cost. As a result, the "bad" (fictional) money tends to drive out the good. In addition, the fictional money creates a false sense of prosperity, leading to malinvestment.

    When something happens to challenge the fictional money system - whether by government interference or natural disaster, the result is a run on the bank. It is during this process that malinvestments are exposed.

    What is a "Real Interest Rate"? It is the interest rate that someone would require to agree to loan you (hard) money that they had honestly saved from excess productivity. Before I take it out of my vault and hand it over to you, I must be very confident that I will get both principal and interest back.

    When Fractional Reserve Banking offers money which has been created "out of thin air" for loan, they are willing to accept a lower rate for it because they didn't have to work for it, and consequently my hard earned money is never loaned, while theirs is had for the taking.

    The real victim here is that the person who worked so hard to save their money is not able to rent it out at a decent rate, because he is competing with dishonest money. If he chooses to loan his savings at the lower rate, he is competing against a system with lower inherent risk, and over time is likely to incur real losses, not the phony losses that the bank experiences.

    Another victim is the rising generation, which learns that saving money is for chumps. It is much more lucrative to game the system and set yourself up using Fractional Reserve Banking money and get other people working for you.

    This is the predicament that America finds itself in. Central banking is merely the ultimate extension of the Fractional Reserve Banking concept. With the loss of any metallic underpinnings in 1971, we now have only fictional money. The central bank creates it by typing on their keyboards and the banks inflate it further through Fractional Reserve Banking (the reserve requirement has all but disappeared as well).

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