Over at The National (best English-language newspaper “review” section in the United Arab Emirates and, indeed, the world) I have a review of George Akerlof and Robert Shiller’s new book Animal Spirits. The review focuses on the idea that the undue influence of neoclassical economics on the minds of policymakers is a crucial contributor to the crisis and an impediment to recovery:
After all, part of the problem with the traditional view is that it’s quite difficult to see how one might actually disprove it — its adherents are in the habit of citing the model itself as a refutation of apparent counter-evidence. For example: by 2005, US home prices were well above their historical average, leading some to conclude that we were in an unsustainable bubble that would soon burst. Alan Greenspan, then the chairman of the Federal Reserve and a strong defender of the rational-actor orthodoxy, argued to the contrary that since it wouldn’t make sense for a bubble to form — since rational homebuyers wouldn’t have inflated one — what we were looking at could not possibly be a bubble.
“For homeowners to realise accumulated capital gains on a residence,” he observed in June 2005, “they must move” — they must sell their homes, an obviously inconvenient transaction. In other words: it wouldn’t makes sense for the rapid rise in house prices to be the result of widespread speculation, so that must not be the cause. And, indeed, it didn’t make sense for people to count unrealised capital gains on their homes as if it were money in the bank, and to respond to notional appreciation in home value by spending beyond their income and racking up credit card and home-equity debt — but that’s what they did.
Akerlof and Shiller argue that such phenomena are actually quite common: the economy is driven not just by the impersonal forces of supply and demand but by “animal spirits” within human culture. During an upswing, powerful narratives take hold and prompt people to take bold risks. Stories of day traders making easy money in the markets and of young geeks making billions overnight dominated the headlines throughout the dot-com boom, while the housing bubble generated endless stories about newly rich home-flippers. The prevalence of such tales ought to signal that a bubble is under way and it’s time to start betting on a turnaround. But in practice, the tendency is for people to be taken in by the wave of enthusiasm.
Common sense, which is wrong about many things because it evolved in a constrained set of circumstances, is actually a font of much wisdom on this subject since predicting how human beings will respond to events is one of the things our common sense was evolved to do capably. And, fortunately, the common sense prediction that people are prone to manias and short-sightedness is well backed-up by empirical research. Standing against this is a body of economic theory that has a lot to contribute, but that leads — always — to precisely this boom-and-crisis cycle whenever it achieves a hegemonic posture in the policy realm.