References: Shiller, R.J., (2000), Irrational Exuberance. Princeton: Princeton University Press.

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1 Book Review Akerlof, G.A., and R.J. Shiller, (2009), Animal Spirits How human psychology drives the economy, and why it matters for global capitalism. Princeton and Oxford: Princeton University Press. 230 pages. This is an important book! Recommended reading for all of us who enjoy reading about economic matters without having to decrypt mathematical proofs based on assumptions we simply cannot accept as descriptive of any reality. This is a popular book arguing the case for questioning those very assumptions. The reason this book was written is, no doubt, the financial crisis. Economists usually describe it as a market failure. That is, had actors in the market only behaved rationally and if markets were not so strictly regulated - this calamity would not have happened. An alternative view would be that there has been a massive managerial failure in the financial sector full, as it is, of organizations. Transaction cost economists say that when the information flow is complex enough it is more efficient to use hierarchy for coordination than market. Right! Whatever is the case it can be explained as a consequence of optimizing costs! So the financial crisis is a managerial crisis. But Akerlof & Shiller, two very prominent economists, are concerned with the inability of mainstream theory to explain what happens in crises and when economies are out of equilibrium (which is most of the time). They use trustworthy, published, empirical research to make their point. How come that the price of a large number of specific products varies with a median difference between maximum and minimum prices of 157 % in the same town (Boston)? To give an example. They describe the results in an easy to understand language, but they also are quite precise with references for readers who want to follow up. Notes in the back, numbered, chapter by chapter, force the reader toggle back and forth while reading, but the academic can live with that. 1

2 The structure of the book is instructive and something for management scholars to consider. First there is a section that introduces five aspects of animal spirits. This is the theory. There are non-rational aspects of human behaviour that play an important part in economic processes. To ignore them in the name of analytical purity is absurd: Evidence abounds for the animal spirits discussed in the first five chapters [..] These are real motivations for real people. They are ubiquitous. The presumption of mainstream macroeconomics that they have no important role strikes us as absurd. (p. 174, italics by the authors). In the second section the animal spirits theory is used to answers 8 questions; Why do economies fall into depression? Why are there people who can t find jobs? Why are financial prices and corporate investments so volatile? Why is saving for the future so arbitrary? - to name a few. A final chapter of conclusion discusses why most of us failed utterly to foresee the current crisis, why have measures to forestall it fallen short, and what needs to be done. The real problem, as we have repeatedly seen in these pages, is the conventional wisdom that underlies so much of current economic theory. (p. 167) This looks promising doesn t it! What is this animal spirits theory? The label, animal spirits (Latin spiritus animalis animal of the mind animating mental energy) comes from Keynes 1936 who argued that it plays a fundamental role in business decisions. He claimed that our basis of knowledge for estimating future cash flows from investments in a railway, a copper mine, a building in the city etc. amounts to little and sometimes to nothing (p. 3). The decisions therefore must be the result of a spontaneous urge to action and not as economics would have it of probabilistic calculation. But in modern use the concept stands for the non-rational component of the economy, relating to our peculiar relation to uncertainty sometimes paralysing sometimes energizing. The authors introduce the 5 aspects by telling a story that gives the reader a feel for what they are after, no doubt to mark the difference to the conventional introduction of concepts by definition. 2

3 The first aspect is confidence (and its multipliers). Economist usually understand confidence as a belief in a rosy future and that information is interpreted and calculated on that basis. But there is more to it! Confidence may cause people to disregard certain information or not even process it rationally, and if information is processed rationally people may not act rationally on the conclusion. And there are multipliers, especially in downturns loss of confidence feeds further loss of confidence banks become reluctant to give credits to banks. The idea of multipliers was made well known by Keynes and Hicks in the 1930s. Economists have not paid enough attention to confidence so far. The second aspect is fairness. Albert Rees, a distinguished Chicago School economist specialised in labour economics, reflecting upon his experience as negotiator and policy maker points to fairness as the factor of overwhelming importance. Again there is plenty of evidence that fairness will override rational motivations, and many articles to refer to, but mainstream economics have pushed them into a back channel of economic thinking. Akerlof & Shiller point to questionnaire studies, experiments, equity theory, and norms (a topic Akerlof, the Nobel Price winner, has written extensively about). The third aspect corruption and bad faith is introduced by way of the good things (like chocolate milk) capitalism has brought humankind. The down side is that capitalism will not produce what people need but what they think they need. Hence the market for snake oil! (Snake oil is a frequently treated product in this book.). So there is a need for consumer protection, especially concerning securities. But it is notoriously difficult to provide. Limited liability works well and enterprises have grown to immense size and complexity. But when there is false accounting the sale of assets may resemble the sale of snake oil. The authors discuss three cases of accounting innovation (called fraud when it was discovered) playing a major role in three past recessions (Savings & Loan, 1991, Enron, 2001, and the current subprime crisis). 3

4 The sign observed on a Boston commuter train: No Smoking General Laws Chapter 272, Sec. 43A Punishable by imprisonment for not more than 10 days or a fine of not more than 50 $ or both introduces the fourth aspect; money illusion. Ten days in prison or 50 $ fine seem highly incommensurable. The sign violates the standard assumption of economics that people do not have money illusions. They are rational and only pay attention to what money can buy, not the formal amount printed on pieces of paper. Fisher illustrated the mistakes people make, since they are unaware of inflation, in the book The Money Illusion in The authors give us the history of money illusion thinking. People simply do not see through the veil of inflation. How can economics insist that they do? And then there are stories, the fifth aspect of the animal spirits theory. Shiller himself (2000) has shown how the story about the invention of the internet played a crucial role in carrying the stock market boom during the late 1990s. Confidence is not just a mental state of the individual, it is transferred to groups and markets through stories just read how your favourite analysts presents his/her conclusions to buy now! Next there is a section that discusses 8 problems where conventional economic theory is at a loss when it comes to explanation. Why do economies fall into depression? is one of them. Why do central bankers have power over the economy? is another. The authors apply the aspects presented earlier to show that they are needed in understanding real economic problems. Since they are such eminent economists and since they are generous with references they convince. There is a need for re-thinking the ontology on which fundamental economic theory building blocks are based. Hopefully this book is part of that process. One could have wished that the two authors would recognize the role of organizations, and discussed how markets become something like organizations through this animal spirit. The aspects they discuss are organizing phenomena! If the authors were successful in persuading their colleagues that the 5 aspects 4

5 must be taken seriously the next step will no doubt be to reconsider the risk concept and how management relates to it. Surely Fisher has to be abandoned for a more general uncertainty concept! But, above all a more comprehensive understanding of economic processes, also those that lead to crisis, need to include more activities than mere asset management. References: Shiller, R.J., (2000), Irrational Exuberance. Princeton: Princeton University Press. 5