Animal Spirits Pt. 4: Conclusion

Having finished this book, I can say I do like what I've read. Certainly I don't agree with every conclusion they've reached, nor do I agree with every analysis. But their approach is certainly more valid than the approach made by even the standard economics stories I'm familiar with. In a way, by acknowledging the fact that individual and cultural variations make most dry quantitative approaches to economic study less than helpful, their approach has more in common with the approach promoted by Ludwig Von Mises than that of those labeled Kensian and Monetarist.

That's not to say they are the same. Where Mises described a discipline that stuck to exploring the structure of logic that can be built upon certain basic, knowable facts (including the fact that human motivations are infinite and complex), Akerlof and Shiller explore the impact of specific psychological and cultural information on economic analysis. Indeed, were one to engage in a multidisciplinary approach that deliberately combined Misesian praxeology with psychology and cultural studies, it would likely look something like this (assuming the reader can accept that "Misesian" and "Rothbardian" are not necessarily the same, and that two people can attempt the same approach and, thanks to the role "understanding" plays in the comprehension of complex phenomena, can come to different conclusions). I can only hope their ideas have some effect on the overall profession.

So this book is a starting point, though I suspect there is a hurdle the authors are not anticipating. They speak of the role of "animal spirits" (and yes, they are using the term in the fashion I had hoped when I wrote Part 1) in shaping the overall economic and driving economic events. They say government regulation is an appropriate remedy to the excesses that can be caused by these "animal spirits". The question then becomes: how do we get appropriate policy out of the government? For it is not only the overall economy in which "animal spirits" plays a role; it is also in politics, and administration, that human motivation plays an important role.

In other words, would would be the result of applying "animal spirits" theory to public choice theory? For the government isn't a machine that inputs information and outputs policy: it, too, is made up of human beings with diverse motives. It, too, suffers from the effects of a confidence cycle, corruption, notions of fairness that may or may not be good for the overall output, changing stories, and other things identified as "animal spirits." Any policy recommendation resulting from an analysis must take this into account as surely as the original analysis must.

Animal Spirits Pt. 3: Natural Wage Theory, Money Illusion, and Wages

I just finished reading Chapter 9 of Animal Spirits. Now I see the point of criticizing Natural Rate Theory. I mentioned in an earlier installment that I suspect that, over the long time, wages will tend to track inflation, but lag behind. Akerlof and Shiller appear to be saying that this is precisely the point. Steady inflation holds wages at a lower level, one which allows a lower level of unemployment. Employers can grant employees raises for the financial purpose of keeping it in line with the purchasing power of money, while still giving the employee the feeling that they are being rewarded for their efforts. In the absence of inflation, the employer can't afford to give so many raises, the employee feels he's not being treated fairly, and worker productivity falters. So, in their analysis, because of money illusion and fairness, a certain level of inflation is required to keep productivity up.

Outside factors they failed to take into account (which I will get into below), I can find no fault with their analysis. Particularly in a world in which people have, over multiple generations, come to regard raises as a regular obligation, perceived unfairness (that very phrase is redundant, given all fairness is subjective) could well result in productivity losses in the absence of inflation-motivated raises.

Of course, this likely leads to the recommendation that a level of inflation should be maintained at all times. Further, it makes something like a commodity money seem untenable. However, there is something else to put into the analysis: the credit cycle. Wages are downwardly rigid, therefore deflation can damage employment levels, as falls in wages fail to keep pace with falls in other prices. But what if "fractional reserve" banking were abolished, and therefore the bank created inflation that ultimately leads to deflation never occurred in the first place? The downward rigidity of wages could become irrelevant, in this scenario. But then, it could also lead to an extended (possibly multigenerational, meaning it would be politically unsustainable in reality) period of adjustment, until people finally realized psychological satisfaction is not going to come from making the numbers bigger.

It's a big hurdle to get over. From a strictly logical standpoint, wages generally rising over time, but lagging behind prices is not as good for workers as wages falling slowly but lagging behind prices. But falling prices, though it is good for a person whose wages have not yet fallen, is an impersonal phenomenon. Rising wages, though, feel like a personal reward, even if the employer is only keeping the wage in line with rising prices, and even lagging behind. The gradual price drops of a stable money supply may be better for workers materially, but rising wages, even insufficient to cover rising prices, are more emotionally satisfying.

Were it not for the dangers inherent in a fiat token-based (whether paper or digital) currency (which we are seeing today, as the results of bad monetary policy hit the economy like a hurricane), a fiat currency would definitely be better... IF the money supply expanded evenly. Unfortunately for fiat money supporters, it does not. Industries grow beyond what they should because of investment bubbles, and then people lose their savings, workers lose time building knowledge and experience in bad industries (not to mention their jobs for no good reason), people lose confidence (which the authors just spent a chapter talking about). I'm presently convinced the negatives of fiat money and an inflationary policy outweigh the negatives.

That, and I have moral difficulties with the idea of a monetary elite making things better by deliberately deceiving laborers.

Animal Spirits Pt. 2: Money Illusion

I am unfamiliar with the term "money illusion", but from what I'm gathering from this chapter as I read it, this refers to the failure by many people to account for changes in the purchasing power of money in their financial planning. In short, the term "money illusion" is kind of like the inverse of another term I am familiar with, "Neutrality of money". Most economists operation under the assumption that money is a neutral medium of exchange. Akerlof and Shiller, in advocating a return to the idea of "money illusion", appear to be saying something similar to what is said in Misesian circles: that money is not neutral.

As evidence of this money illusion, the authors point out that the vast majority of labor contracts fail to include wage increases to account for cost-of-living increases. In other words, in the vast majority of cases, workers bargain in monetary terms, not in "real" terms. But, there is another explanation other than "money illusion". It could be that both sides are simply less concerned with future prices than they were with current prices. The workers want to get as much as they can right now, gambling that future negotiations will enable them to keep up with the costs of living. The employers want to avoid built-in cost increases, and gamble that future negotiations will enable them to avoid excessive wage increases. Since nobody can truly predict the future, neither side can effectively negotiate in terms of future wages.

Then again, that whole argument could be the same thing as "money illusion". I'm still not sure what it means, exactly.

Still, if it is true that, as Akerlof and Shiller assert, conventional economists (I suspect they are referring to monetarists here) actually make the assumption that people see through the veil of inflation naturally... I weep for the profession. I suspect, however, that there is more to it than this.

In the sort term, of course many people are going to fail to account for inflation. People differ in their degree of financial savvy. Furthermore, people who maintain minimal savings have little to lose from inflation (aside from wage erosion, but those are not entirely under their control in the first place), and thus have little incentive or opportunity to think in terms of inflation. So if monetarists, when they say people behave "rationally" and "see past" inflation (in the authors' words), actually mean people are smart and know about inflation... obviously they fail. Hard.

However, though wages for unskilled labor will always tend to lag behind inflation, they will also tend to track inflation, quite in spite of the worker's lack of knowledge about inflation. For workers are not aiming at a specific level of "real wages". They are simply trying to get as much value out of their jobs as possible (including money, but also including such intangibles as job satisfaction, job security, risk aversion both physical and psychological, etc.). Likewise, their employers are not trying to maintain some specific "real value" in their wage rates, but are rather, day to day, simply trying to get as much value out of as little money as they can. Inflation is entirely irrelevant in this calculation, so long as both parties are dependent on that third, unassailable economic force: the consumer, who is simply trying to get as much value for as little money as possible, also. (Most labor contracts I am familiar with that include COLAs are those of government workers, such as teachers, who are not dependent on the consumer, but rather the taxpayer and the voter; entirely different incentives apply.)

So as workers move from job to job, they will tend to go with the highest bidder, regardless of who that is. Someone who fails to get a raise he thinks he deserves may attempt to move to a different company. A company that finds its wages too high and finds themselves unable to lower those wages will tend to look for excuses to fire overpaid workers outright, replacing them with new workers with whom they can negotiate lower wages. Whether either party will be successful is ultimately not up to either the employers and the workers, regardless of whether or not they "understand" inflation, but to market conditions as dictated by the consumers.

However, "money illusion" will still tend to skew the economy. Downward wage rigidity is part of this. Consumer resistance to price rises is another. The "wealth effect", in which people tend to spend more when the monetary value of their assets rises despite the unchanged form of those assets, is another. All these forms of resistance will ultimately crumble in the long term, as market realities force reassessments; however, these "money illusion" phenomena do tend to transform what should be gradual changes over time into sudden and traumatic lurches, which skew perceptions and beliefs even more.

At this point in the book, the authors have failed to point out the source of money illusion. Some changes in prices simply reflect changes in consumer disposition: a price for one thing drops because consumers value it less today than they did yesterday, or because costs in producing this good have dropped; a price for another thing rises, because consumers value it more today than they did yesterday, or because production costs have risen. However, when ALL prices rise, it can only be because consumers value the money, itself, less today than they did yesterday, OR because the supply of money itself has risen. And there is only one entity with the power to increase the money supply to the degree it has over the twentieth century: the State. This "illusion" is not a natural phenomenon: it is man made. I hope to see Akerlof and Shiller point out this fact later in the book.

Animal Spirits

A friend of mine and I occasionally discuss questions of politics and economics. He recently read George A. Akerlof's and Robert J. Shiller's Animal Spirits. At his recommendation, I am also reading it. Of course, I can't help but read it from the Misesian perspective I've been absorbing as I read through Von Mises's Human Action. I'll be using this space to comment as I read through.

I just finished the introduction. So far, I have only two problems with the text. The first is the implication that the Classical model of economics (which Akerlof and Shiller are calling "traditional economics") was somehow the last word in economics before the entire profession was awakened by first the Great Depression and, today, this recent series of closely followed crashes. This is not true, as in both cases there were those who successfully predicted the events (and were at the time universally derided for it). Ludwig von Mises, for example, successfully predicted the Great Depression as the inevitable result of Federal Reserve policy during the "Roaring Twenties." More recently, Peter Schiff, a follower of the same set of ideas, called this recent recession several years before it materialized.

There are similarities between the Misesian approach to economics, and the approach proposed by Akerlof and Shiller in this book, which brings me to the second problem I have: the terminology the authors chose to employ. For while "Animal Spirits" may have good book-selling shock value, the term is highly misleading in that it has both a surface meaning (the new-agey ideas about totems and ghosts and stuff the average reader would get from it) and the more archaic meaning the authors are using, which simply refers to the fact that human beings make their own decisions according to the world as they see it, rather than the world as it actually is (or rather, I dearly hope this is what they are getting at).

This is similar to Von Mises' approach, which he termed methodological dualism. Von Mises, in Human Action, briefly alludes to the philosophical debate about whether or not human beings have "souls" or "spirits", whether or not people have free will or are slaves to a chain of cause and effect going back billions of years that determines what we do. He then dismisses these questions as being outside the scope of economics and without satisfactory answer as of the writing (and even as of today, so far as I can tell). According to Mises, to be correct, the economist must theorize as if people have the ability to decide upon action independently of this chain of cause and effect the strict materialist believes determines our actions, since economics has no way of following this chain beyond the confines of the human mind (the way I always put it is that, from the perspective of economics, the mind is a black box), and psychology, as yet, cannot follow it reliably. Thus the term methodological dualism. The term "dualism" refers to the idea that there are two sources of "cause" in the universe: the physical chain of cause and effect that can be analyzed and predicted by the physical sciences, and the actions of human beings which cannot. The term "methodological" refers to the fact that the economist is laying no claim to the the truth of the idea of human free will... merely that this assumption is a requirement for economic analysis under the current scientific conditions.

In other words, these ideas are hardly new... they simply have never been taken seriously in the context of mainstream economics (whether neoclassical or Keynsian). I'm looking forward to getting to the meat of this book and seeing where the authors go with this.