May 17 2010

Animal Spirits, Complexity, and “The Most Dangerous Guy Out There”

Published by at 10:20 pm under Wave Guide 1: Economic Growth

New York Times Magazine (5/16/10; B. Wallace-Wells) features a revealing profile of former Chicago professor and current Obama regulatory czar, Cass Sunstein. A profound devotee of behavorial economics — which assumes that human irrationality is predictable — Sunstein commented that its elaboration “is the most exciting intellectual development of my lifetime.”

Did positive Keynesian Animal Spirits drive both the Panama Canal in 1914…

… and the Apollo program in 1969? Click .

The Times’ piece is of interest to us at because John Maynard Keynes — the first prominent behavorial economist — invented the concept of “animal spirits” to explain the crucial role of confidence (both optimism and pessimism) in the economy. Conceptually, animal spirits appears related to “ebullience” which — through the psychologically expansive effects of Maslow’s hierarchy — triggers public support for great explorations and MEPs.

In fact, animal spirits and ebullience may be two sides of the same coin. For example, positive animal spirits stimulate actors in the economy to produce a boom. While ebullience, although typically affluence-induced, operates in the elevated Maslow (self-actualizing) mode and makes great expectations and MEPs seem almost irresistible. Negative animal spirits rapidly terminate the boom, erode ebullience, collapse society’s elevated Maslow state, and “close” the Maslow Window.

But the Times explains that not everyone is happy with Sunstein’s vision.

Conservatives see a Big Brother strain in Sunstein’s philosophy (Glenn Beck called him “the most dangerous guy out there”), while some liberals worry that behavorial economics is too immature to handle the weight of guiding policy.

This is partly because of two Sunstein beliefs:
1) the idea that the human quality of irrationality can be predicted,
and, according to the Times,
2) “this is the controversial part — that if the social environment can be changed, people might be nudged into more rational behavior.”

Animal Spirits Exist
More interesting at this point — given the still-embryonic state of the science — is the recent discovery by a University of California, Irvine economist that animal spirits are actually important to business cycles (Investers Chronicle, 3/26/10; C. Dillow). Fabio Milani compared the expectations of individual economic forecasters (from the Survey of Economic Forecasters) with a learning model featuring a “rational expectations solution” to the system. According to Milani,

Private sector agents in some periods may be overly optimistic — by forecasting a higher future output or lower inflation rate, for example, than implied by their learning model — or overly pessimistic. These waves of over-optimism and over-pessimism, which are exogenous to the state of the economy, are defined as the expectation shocks in the model.

Milani’s “expectation shocks” can account for more than half of the variation in the U.S. GDP over the last 40 years. Not only did his expectation shocks fall before each of the last 7 recessions, they are near an all-time low now. Thus animal spirits, expectation shocks, and ebullience are apparently at work during business cycles.

The Market is a Complex Adaptive System
Herbert Gintis (3/31/2009) of the Santa Fe Institute modeled the market in 2007 as an agent-based complex adaptive system. In his review of Akerloff and Shiller’s book, Animal Spirits (2009), Gintis suggests that animal spirits are only part of the story:

The major thesis of the book is only partially correct in attributing macroeconomic instability to human foibles … Akerlof and Shiller do not have enough evidence to assert confidently that people are driven by irrational animal spirits to produce market volatility. People imitate the successful, both in my agent-based model and in real life. This is generally quite rational behavior, but it can produce “behavioral cascades” that are destabilizing

Part of the confusion apparently arises because of evolving conditions that affect the notion of “rational” versus “irrational.” Is it rational for investors and businesses to join the bandwagon when a strong upward economic trend has been established? Probably yes. On the other hand, is it irrational for investors and businesses to assume that the boom will continue forever? Yes, for sure.

Therefore, investors who were initially rational may become irrational as the boom peaks. This is especially true when the system becomes strongly fractal and increasingly unpredictable.

It appears that animal spirits have an empirical foundation and, together with ebullience, are able to explain the psychological rationale behind widespread public support for great explorations and MEPs during Maslow Windows. The fact that public support is short-lived and that Maslow Windows display punctuated equilibrium — e.g., are separated by 55 to 60 years — is consistent with the idea that we’re dealing with a complex adaptive system that requires 5 – 6 decades to repeatedly self-organize into a critical state (the Maslow Window).

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