At last, I completed the book Animal Spirits, which I added to my reading list nearly two months ago. The book, written by Berkeley economist George Akerlof and Yale economist Robert Shiller, is fabulous.
Why, then, did it take so long for me to complete it? It is not because the book is long or difficult. It is neither. In fact, it is a joy to read. I neglected it only because I was busy with a study of off-farm work and migration in China. This work, plus social activities, absorbed nearly all my available time.
As I mentioned before, Akerlof (1940-) shared the 2001 Nobel Prize in Economics with Michael Spence and Joseph Stiglitz. Robert Shiller (1946-) is an expert in the field of finance who makes frequent appearances on Thought du Jour.
If you read no other book on the current financial crisis, this should be the one. Here is an excerpt, from chapter 11 “Why Are Financial Prices and Corporate Investments So Volatile?”:
No one has ever made rational sense of the wild gyrations in financial prices, such as stock prices. ….
The real value of the U.S. stock market rose over fivefold between 1920 and 1929. It then came all the way back down between 1929 and 1932. The real value of the stock market doubled between 1954 and 1973. Then the market came all the way back down. It then lost half of its real value between 1973 and 1974. The real value of the stock market rose almost eightfold between 1982 and 2000. Then it lost half of its value between 2000 and 2008.
The question is not just how to forecast these events before they occur. The problem is deeper than that. No one can even explain why thee events rationally ought to have happened even after they have happened.
One might think, from the self-assurance that economists often display when extolling the efficiency of the markets, that they have reliable explanations of what has driven aggregate stock markets, which they are just keeping to themselves. [They don’t!]
George Akerlof and Robert Shiller, Animal Spirits: How human psychology drives the economy and why it matters for global capitalism (Princeton University Press, 2009), p. 131.
So, what does account for wild swings in stock prices? “Animal spirits”, according to Akerlof and Shiller. But does this knowledge help us predict stock prices? Sadly, I fear not. But it is important to know what we do not know. Economists need to be more humble and not promise what we cannot deliver.
By the way, what are “animal spirits”, those strange beasts invoked by Akerlof and Shiller? I will discuss them in a future post.