Nov 13th 2008

Finance in the 21st Century: Reviving the Animal Spirits

NEW HAVEN - The world's fundamental economic problem today is a staggering loss of business confidence. Commercial banks, investment banks, and hedge funds all owe their ongoing trouble to its decline, which in turn is jeopardizing the plans of companies and entrepreneurs to launch enterprises and make investments, and of households to consume.

Our "animal spirits," to borrow a phrase made famous by John Maynard Keynes, are weakening. George Akerlof and I have just written a book by the same name, but by the time Animal Spirits appears later this winter, the world economy may be even worse than it is now.

Nations everywhere are starting to implement aggressive stimulus and bailout packages. Yet the economic outlook still looks grim. The International Monetary Fund's latest forecast predicts that the world's advanced economies will contract 0.3% in 2009 - the first such shrinkage since the end of World War II.

Part of the difficulty of contending with a crisis of confidence is that it is hard to quantify confidence in the first place. The Conference Board Consumer Confidence Index in the United States, begun in 1967, fell in October to its lowest value ever. The latest Nielsen Global Consumer Confidence Index, which covers 52 countries, fell to 84, from 137 when it was launched in 2005.

But these surveys, which tabulate quick answers to simple questions, do not tell us how deeply held these opinions are, how new circumstances might change confidence, or what people will really do when they make important decisions in coming months or years.

This decline in confidence is fundamentally related to the chaos in the financial markets that started in 2007 and accelerated this September. The specter of collapsing financial institutions around the world, and desperate government bailouts to try to save them, has created a general sense of alarm.

Then there is the effect of memory on today's animal spirits. People know enough about the Great Depression to understand that there are parallels with today. Many know that interest rates on three-month US Treasury bills became slightly negative in September 2008 - for the first time since 1941. People are also aware that the stock market has not been this volatile since the Great Depression (with the single exception of October 1987). Beyond that, national leaders are defending extraordinary bailout measures by not-so-veiled comparisons to the Great Depression.

Animal spirits are not always shattered by extraordinary economic events. But then, not all economic convulsions are alike. For example, the October 19, 1987, stock market crash was the biggest one-day drop ever. The Standard & Poor's Composite fell by 20.5%, the FTSE 100 by 12.2%, and the Nikkei 225 by 14.9% the next day. The crisis spread around the world, but there was no recession. Instead, world stock markets recovered, creating a colossal bubble that peaked 13 years later, in 2000.

In a survey that I conducted immediately after the 1987 crash, I found that the biggest concern expressed by individual and institutional investors in the US was essentially that the stock market had been overpriced. After the crash corrected that problem, many people apparently did not feel there was much more to worry about. The only parallel to the Great Depression was the stock market drop itself. Moreover, many financial experts blamed the 1987 crash on a kind of programmed trading called "portfolio insurance," which most thought would stop.

But recent events do not carry such a rosy interpretation. The stunning magnitude of recent declines cannot be dismissed as a one-day anomaly caused by a technical trading glitch.

The week of October 3-10 was the worst stock market week in the US since the Great Depression, while Japan's stock market performed worse than it did in the worst week of the Asian financial crisis ten years ago. Similarly, Mexico's stock market performed about as badly as it did during the worst week of the Mexican financial crisis in 1995, and Argentina's stock market roughly matched the worst weekly drop during the country's financial crisis of 1997-2002. Extraordinary stock market volatility, both up and down, has continued since.

The current stimulus and bailout plans were hatched in reaction to that dreadful week. The G-7 countries announced a coordinated plan to fix the world economy on October 10, and that weekend the G-20 countries endorsed the plan. But stock markets were barely higher in early November. In China and India, they were lower.

The erosion of animal spirits feeds on itself. Immense market volatility serves only to reinforce people's sense that something is really wrong. A volatility feedback loop begins: the more volatility, the more people feel they must pay attention to the market, and hence the more erratic their trades.

Perhaps the saving grace in this situation is that animal spirits can and sometimes do change direction. Confidence is a psychological phenomenon, and can make seemingly capricious jumps up as well as down. The most promising prospect for a return of business confidence now would be some kind of public inspiration. In the US, President-elect Barack Obama seems to have the charisma to create this, and his status as the first minority president marks a major historical transition that might have great positive psychological impact in the US and around the world.

Whatever the near future holds the multitude of plans now being discussed to deal with this global crisis need to be judged with attention to the elusive and inexplicable effects they might have on confidence. The "animal spirits" that Keynes identified generations ago remain with us today.

If you wish to comment on this article, you can do so on-line.

Should you wish to publish your own article on the Facts & Arts website, please contact us at info@factsandarts.com. Please note that Facts & Arts shares its advertising revenue with those who have contributed material and have signed an agreement with us.

Please watch below Robert J. Shiller being interviewed by Ben Tate of Princeton University about his recent book "The Subprime Solution: How Today's Global Financial Crisis Happened, and what to do about it". The video is in two parts:

Part 1:

Part 2:

Browse articles by author

More Current Affairs

The Case for Ukraine's EU Membership
by Charles Tannock
Jul 2nd 2022
EXTRACT: "...EU enlargement is essentially a political decision by member states, based on a multitude of considerations that sometimes include dramatic events. Russia’s war of aggression against Ukraine is such a turning point."
A Stagflationary Debt Crisis Looms 
by Nouriel Roubini
Jun 29th 2022
EXTRACT: "Most market analysts seem to think that central banks will remain hawkish, but I am not so sure. I have argued that they will eventually wimp out and accept higher inflation – followed by stagflation – once a hard landing becomes imminent, because they will be worried about the damage of a recession and a debt trap, owing to an excessive build-up of private and public liabilities after years of low interest rates." ----- "There is ample reason to believe that the next recession will be marked by a severe stagflationary debt crisis. As a share of global GDP, private and public debt levels are much higher today than in the past, having risen from 200% in 1999 to 350% today (with a particularly sharp increase since the start of the pandemic). Under these conditions, rapid normalization of monetary policy and rising interest rates will drive highly leveraged zombie households, companies, financial institutions, and governments into bankruptcy and default."
When Central Bankers Become the Target 
by Howard Davies
Jun 28th 2022
EXTRACT: "It is tempting to conclude that today’s central bankers are damned if they do and damned if they don’t. Maybe if they sit tight, they will ride out the storm. Then-Fed Chair Paul Volcker was Public Enemy Number One in the United States in the early 1980s, when he squeezed post-oil-shock inflation out of the system with double-digit interest rates. But in his later years he was revered, and became a national treasure, called on to advise successive presidents in any financial emergency. ----- But central bankers would be wise not to assume that their reputations will automatically recover, and that the status quo ante will be restored. We live in a more disputatious age than the 1980s. Public institutions are more regularly challenged and held to account by far less reverential legislators." ----- "Moreover, former central bankers have joined the chorus of critics. Former Fed Chair Ben Bernanke, breaking the unwritten rule not to reproach one’s successors, has said that today’s Fed made “a mistake” by responding slowly to inflation. And Bailey’s immediate predecessors, Mervyn King and Mark Carney, have weighed in, too, with challenges to the BOE’s policy. The fabric of the central banking fraternity is fraying."
Ukraine war: fears that Belarus might invade on Russia’s side are growing
by Stefan Wolff and Tatyana Malyarenko
Jun 25th 2022
EXTRACT: "Public opinion in Belarus remains firmly against involvement into the war with Ukraine. Moreover, according to a Chatham House survey, 40% of Belarusians do not support Russia’s war, compared to 32% who do, while around half of those questioned see predominately negative consequences of the war for Belarus (53%) and for themselves (48%). The Belarusian military and security services are also aware of the determined and skilful resistance that Ukrainian forces have put up against Russia and the risks that they would therefore be running if they entered the war against Ukraine. This, in turn, means that the risk to Lukashenko himself remains that he might lose his grip on power, a grip which depends heavily on the loyalty of his armed forces." ---- "Ultimately, Belarus may not be on the brink of being plunged into war quite yet, but its options to avoid such a disaster are narrowing."
Why Putin’s policy towards Ukraine has strong parallels to Stalin’s post WWII plan for Germany
by Paul Maddrell
Jun 20th 2022
EXTRACT: "Russification (the policy of enforcing Russian culture on populations) appears to be being reinforced by ethnic cleansing. Last month the Ukrainian parliament’s commissioner for human rights, Liudmyla Denisova, informed the United Nations’ High Commissioner for Refugees, Filippo Grandi, that 1.3 million Ukrainians, including 223,000 children, had been forcibly deported to Russia."
A Treasonous President And A Nation In Peril
by Alon Ben-Meir
Jun 11th 2022
EXTRACT: "If Trump had his way, then Vice-President Pence would have also broken his oath to the constitution and derailed the certification of electoral votes. Our continued existence as a Republic might very well have hung on Pence’s actions that day. The mob’s response was to call for Pence to be hanged, and a noose and scaffold was erected apparently for that very purpose. What was Trump’s reaction when he was told that the mob was calling for Pence’s summary execution? His words were: “Maybe our supporters have the right idea.” Mike Pence “deserves” it."
Ukraine: Russian attitudes to Ukrainians can help to explain the atrocities
by Kseniya Oksamytna
Jun 10th 2022
EXTRACTS: "Speaking to journalist Sophie Raworth on the BBC’s Sunday Morning show recently, former war crimes prosecutor Sir Howard Morrison, now an advisor to the Ukraine government, highlighted the dangers posed by the negative – often insulting and dehumanising – statements made by some Russian politicians and media personalities about Ukraine and its people." ---- "The conditions and attitudes described by Morrison have existed for centuries: Russians have viewed Ukrainians as inferior since before the Soviet era." ----- "And, as Morrison said, stereotyping and denigrating a people as inferior or lacking agency makes atrocities and looting more likely to happen, as we are seeing in Ukraine."
Ukraine: international pressure needs to be on Moscow, not Kyiv
by Stefan Wolff and Tatyana Malyarenko
Jun 9th 2022
EXTRACT: "Unless Russia realises that the west is willing and able to push back, a new, stable security order in Europe will not be possible. Concessions to Russia, by Ukraine or the EU and Nato, are not the way to achieve this. That this has been realised beyond Ukraine’s most ardent supporters in the Baltic states, Poland, the UK and the US is clear from German support for strengthening Nato’s northern flank and a general increase in Nato members’ defence spending."
Stop Blaming the Russian Soul 
by Ian Buruma
Jun 8th 2022
EXTRACT: "Highly civilized people can turn into barbarians when demagogues and dictators exploit their fears and trigger their most atavistic instincts. Rape, torture, and massacres often happen when soldiers invade foreign countries. Commanding officers sometimes actively encourage such behavior to terrorize an enemy into submission. And sometimes it occurs when the officer corps loses control and discipline breaks down. Japanese and Germans know this, as do Serbs, Koreans, Americans, Russians, and many others."
Kissinger is dead wrong about the Russian war against Ukraine
by Alexander J. Motyl
Jun 1st 2022
EXTRACTS: "Like Metternich, Kissinger commits the fatal error of believing that a few wise policymakers can impose their will on the world. Worse, he believes they can halt domestically generated change and the power of nationalism. Many years ago, this is what Senator William Fulbright termed the “arrogance of power.” This approach failed in Vietnam, Iraq, and Afghanistan. It is also doomed to fail in Russia and Ukraine." ------ "Not surprisingly, Kissinger misunderstands Russia. He appears to believe that, because Russia has been an “essential part of Europe” for over four centuries, it is therefore fated to remain so for the foreseeable future.The claim is completely at odds with history." ---- "Finally, Kissinger misunderstands the implications of his own analysis for Western relations with Russia. “We are facing,” he said, “a situation now where Russia could alienate itself completely from Europe and seek a permanent alliance elsewhere." ---- "But what’s so bad about Russia’s isolating itself from Europe and becoming a vassal state of China? "
China’s population is about to shrink for the first time since the great famine struck 60 years ago. Here’s what it means for the world
by Xiujian Peng
Jun 1st 2022
EXTRACTS: "According to the latest figures from China’s National Bureau of Statistics, China’s population grew from 1.41212 billion to just 1.41260 billion in 2021 – a record low increase of just 480,000, a mere fraction of the annual growth of eight million or so common a decade ago." ----- "China’s total fertility rate (births per woman) was 2.6 in the late 1980s – well above the 2.1 needed to replace deaths. It has been between 1.6 and 1.7 since 1994, and slipped to 1.3 in 2020 and just 1.15 in 2021."
Ukraine war: despite Russia’s success in Donbas, this is only the end of the beginning
by Frank Ledwidge
Jun 1st 2022
EXTRACTS: "Casualties are very high. A very conservative estimate of overall Russian losses is that they have lost more troops killed since February 24 than in ten years of fighting in Afghanistan. This implies well over 40,000 men taken out of the fight, including the wounded." ----- "Away from the cauldron of Donbas, Belarus has been rattling its somewhat rusty sabre by deploying troops to its border with Ukraine. This is unlikely to trouble Kyiv. The Belarus president, Alexander Lukashenko, is well aware that he may need them at home to shore up his shaky regime."
Don't Bet on a Soft Landing 
by Nouriel Roubini
May 27th 2022
EXTRACTS: "Monetary policymakers are talking tough nowadays about fighting inflation to head off the risk of it spinning out of control. But that doesn’t mean they won’t eventually wimp out and allow the inflation rate to rise above target. Since hitting the target most likely requires a hard landing, they could end up raising rates and then getting cold feet once that scenario becomes more likely. Moreover, because there is so much private and public debt in the system (348% of GDP globally), interest-rate hikes could trigger a further sharp downturn in bond, stock, and credit markets, giving central banks yet another reason to backpedal." ----- "The historical evidence shows that a soft landing is highly improbable. That leaves either a hard landing and a return to lower inflation, or a stagflationary scenario. Either way, a recession in the next two years is likely."
Jerome Powell's Volcker Deficit 
by Stephen S. Roach
May 26th 2022
EXTRACT: "No, I am not arguing that Powell needs to replicate Volcker’s tightening campaign. But if the Fed wishes to avoid a replay of the stagflation of the late 1970s and early 1980s, it needs to recognize the extraordinary gulf between Volcker’s 4.4% real interest rate and Powell’s -2.25%. It is delusional to believe that such a wildly accommodative policy trajectory can solve America’s worst inflation problem in a generation."
Ukraine war: rising food prices are not the only global economic fallout
by Stefan Wolff and Tatyana Malyarenko
May 26th 2022
EXTRACT: "It will be critical in this context how China will act and whether it will prioritise its economic interests (continuing trade with Europe and the US) or current ideological preferences (an alliance with Russia that makes the world safe for autocracies)."
‘Wine time Friday’ and invites for 200: five of the most interesting findings from Sue Gray’s partygate report
by Chris Stafford
May 26th 2022
EXTRACT: "The document is full of embarrassing and damming stories of illegal gatherings and bad behaviour. There was “excessive alcohol consumption”, a regular fixture referred to as “wine time Fridays” and altercations between staff. Aides are shown to have left Downing Street after 4am (and not because they had worked into these early hours). Cleaning staff and junior aides were abused, and a Number 10 adviser is on record before the infamous “bring your own booze” party...."
The Imperfect Shape of Peace in Ukraine 
by Shlomo Ben-Ami
May 17th 2022
EXTRACT: "But even a resounding Russian defeat is an ominous scenario. Yes, under such circumstances – and only such circumstances – Putin might be toppled in some kind of coup led by elements of Russia’s security apparatus. But the chances that this would produce a liberal democratic Russia that abandons Putin’s grand strategic designs are slim. More likely, Russia would be a rogue nuclear superpower ruled by military coup-makers with revanchist impulses. Germany after World War I comes to mind."
Ukraine: Nato and the US aim to destroy the Russian military – it looks as if they may have the means to do it
by Frank Ledwidge
May 4th 2022
EXTRACT: ".....a remarkable transformation is taking place in Ukraine’s army amounting to its de facto military integration into Nato. As western equipment filters through to the frontline, Nato-standard weaponry and ammunition will be brought into Ukrainian service. This is of far higher quality than the mainly former Soviet weapons with which the Ukrainians have fought so capably. The longer this process continues and deepens, the worse the situation will be for the already inefficient Russian army and air force."
Tough Times Ahead for Russian Studies
by Alexander J. Motyl
May 3rd 2022
EXTRACT: " The conventional wisdom among students of the Russian arts and sciences is that Russian culture is “great.” The problem is that, while there are surely great individuals within Russian culture, the culture as a whole cannot avoid responsibility for Putin and his regime’s crimes." ---- "Russianists will not be able to avoid examining themselves and their Russian cultural icons for harbingers of the present catastrophe. What does it mean that Fyodor Dostoevsky was a Russian chauvinist? That Nikolai Gogol and Anton Chekhov were Ukrainian? That Aleksandr Solzhenitsyn was an unvarnished imperialist? That Aleksandr Pushkin was a troubadour of Russian imperial greatness? May these writers still be read without one eye on the ongoing atrocities in Ukraine?"
Russia’s long journey from partner of the west to pariah reflects a huge failure of its diplomacy
by Anna-Sophie Maass
Apr 29th 2022
EXTRACT: "The following day Lavrov met his Eritrean counterpart, Osman Saleh, in Moscow. Eritrea was the only African country to vote against the UN resolution condemning the invasion. In this refusal to condemn Russia, Eritrea was joined by only Belarus, North Korea and Syria. Even longstanding allies such as Cuba and China abstained. It’s an indication of Russia’s increasingly limited diplomatic options as this war continues."