Let’s face it at some time or other over the last few months we have sat around with friends or business colleagues and the conversation has gotten around to – how the hell did we get in this mess? Yes the usual answer is it wasn’t our fault it was the bankers or the government or those darn speculators etc. But human nature being what it is we usually find someone else to blame. However, in the wider context of why did banks, pension funds and usually ultra cautious municipal authorities get in the position of owning all kinds of debt instruments that have subsequently proved to be almost worthless. can be answered in a new book. “Animal Spirits:How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism” published by Princeton and reviewed in the Financial Times goes some way to explaining the psychology involved, available from Amazon of course.
The authors, George Akerlof and Robert Shiller, review observations made by John Maynard Keynes in his 1936 book The General Theory of Employment, Interest and Money, which was written during the Great Depression and add to it modern observations of behavior and economics. Keynes work has become widely accepted as the middle way between communism and raw capitalism. His concept that government has a role in counter balancing the inherent instabilities in the capitalist system, by running a deficit in times of need and paying it back in times of plenty, has long been accepted on both sides of the Atlantic. One area Keynes discusses but which does not get as much coverage is why capitalism breaks down from time to time. If markets correctly followed the principles laid down by Adam Smith they would always be in balance; the sum total of individuals pursuing their personal aims results in a stable and productive economy. In reality of course, this doesn’t happen for long, we have bubbles, booms and busts. On an individual or corporate level, Smith would expect that all investments would be made only after a full and detailed analysis of the risks and rewards by the parties concerned. In reality this too often doesn’t happen. Individuals and therefore the organizations for which they work have different levels of appetite for risk depending on their level of confidence in the future. Individuals can be incredibly trusting if they are told stories of success that appear to be widely accepted, see for example the huge sums of money invested in schemes like the Madoff funds. Banks with departments stuffed with highly qualified PhD graduate analysts invested mind boggling sums in credit derivatives without (in hindsight) really understanding the risks.
Why? Why do individuals, corporations and organizations get themselves in such situations? Keynes had an explanation; he called it Animal Spirits, observing that in times of upswing business people are willing to invest in ventures over which they, in reality, have only the haziest ability to predict the outcome. Drawing on modern studies in behavioral psychology and economics the authors explore how human behavior has always been influenced by the stories we hear and that reassured by these stories we are swept along and our appetite for risk increases. Look at the collective enthusiasm for the dot com bubble and then speculative property buyers, flippers. It was like a herd instinct. Early stories of success fueled further investment and for a while it became self-fulfilling.
The counterbalancing role of government in this case would be financial regulation requiring organizations to observe codes of behavior, such as disclosure and reporting that made a fair assessment of the risks possible ” which brings us back to Adam Smith’s position that capitalism requires investment decisions to be made only after careful analysis of all the data in order for it to function efficiently. An example just this week concerning trading limits on futures exchanges was discussed in a Reuters article. With many parties calling for tighter regulation of markets it would appear there is a consensus that government has a role to play in ensuring we do not allow our Animal Spirits to get the better of us in the future. The authors’ concern is that rushed government intervention more often causes problems than solves them.