Free markets need strong institutions to deliver the right economic outcome

 

BOOK REVIEW: PASCHAL DONOHOEreviews Animal Spiritsby George Akerlof and Robert Shiller; Princeton University Press; £16.95 (€18.50)

THE QUEEN recently visited the London School of Economics. I imagine such visits are very stiff occasions. The atmosphere heated up considerably when the queen asked the economists why they had not predicted the credit crunch. This questioning was so terse that the Royal British Academy published a lengthy response to Buckingham Palace.

This was a high-profile example of the questions now being asked of the economics profession. The Economistsummed up many of these doubts in a recent editorial entitled “What went wrong with economics”.

Animal Spiritsis a very timely answer to that question. The pedigree of the authors gives hope that they will be able to tell the reader where their profession went wrong, and how economists could redeem themselves.

Gary Akerlof is a Nobel Prize winner in economics. His co-author, Robert Shiller, coined the phrase “Irrational Exuberance” regarding housing and stock market bubbles. Alan Greenspan made the phrase famous. Queen Elizabeth would approve of Prof Shiller, as he predicted the eventual collapse of the US housing market.

This book re-examines the legacy of the great economist John Maynard Keynes. It argues that some of his greatest insights have been marginalised due to attempts to place his thinking in a mathematical framework.

Keynes recognised that these “Animal Spirits” have been at the centre of how consumers make spending and saving decisions. The authors argue that modern economic theory assumes perfect rationality, where bad decisions can only be the result of a lack of information, or bad information.

This is at odds with Keynes, who recognised that economic life can be marked by the absence of rationality in decision-making. This book aims to re-assert this tradition. It argues that economic theory should start with departures from pure rational decision-making.

Examples of these departures could include: why the vast majority of house buyers and owners assumed house prices would never drop significantly. The answers to such questions of human behaviour are “Animal Spirits”. They include confidence, fairness and antisocial behaviour, money illusion and stories. The book works through each “spirit” and explains how they explain a pressing economic question.

Akerlof and Shiller argue that economists are reluctant to use concepts such as fairness, as they do not fit easily into mathematical modelling. This reluctance has undermined the relevance of these theorists to the great economic questions of our day.

The authors recommend a far more activist role for government in economic life. The book gives a firm framework for explaining why free markets need strong public institutions to deliver the right outcomes for societies.

The pressures of the McCarthy report and rising levels of public debt provide the backdrop for this support for government intervention. This is the dilemma.

We need government to ensure financial markets do not destroy the real economy, to provide the infrastructure for new markets and to save our environment. However, we cannot afford the current cost of the government, let alone more of it.

Animal Spiritsis exceptional in showing how economics can be accessible and relevant in dealing with this awesome challenge.


Paschal Donohoe is a member of Seanad Éireann. He was formerly the commercial director for Procter & Gamble Ireland