On Animal Spirits and Knee-Jerk Reactions

A couple of weeks ago Robert Shiller published a piece in the New York Times in which he explored the role of mass psychology in generating business cycles, and argued that "the economic recovery that appears under way may be based on little more than self-fulfilling prophecy." This led Mark Thoma to respond as follows:

I find that I have a knee-jerk, negative reaction to explanations based upon mass psychology, sentiment, story-telling, and the like. I have to consciously force myself not to dismiss them. I'm not sure why that is, though it probably has something to do with a feeling that such explanations aren't scientific, and hence have no place in serious academic investigations. That is, prior to the crisis I thought that the real economy drove sentiment, and not the other way around. Sentiment could definitely provide a feedback loop that strengthens negative or positive economic shocks, but psychology was not the prime mover. Thus, sentiment changes that did not have evidence to support them would quickly die out before having much, if any effect.

But this crisis has caused me to reevaluate. I still find the Shiller-type animal spirits, psychology based explanations hard to swallow, but when the foundation supporting your beliefs is called into question (in this case modern macroeconomic models), it's important to open your mind and at least give alternative explanations a chance. That's particularly true when the person pushing the stories has a pretty darn good record of using them to warn of bubbles, as Shiller does. So I'm trying.

This captures my sentiments almost exactly. I'm trying. I too have the greatest respect for Shiller and consider his 1981 paper on stock price (relative to dividend) volatility to be an absolute classic. But I can't help thinking that too much is being asked of behavioral economics at this time, much more than it has the capacity to deliver. In an earlier post on Elinor Ostrom I expressed this view as follows:

Behavioral economics... has been very successful in identifying the value of commitment devices in household savings decisions, and accounting for certain anomalies in asset price behavior. But regularities identified in controlled laboratory experiments with standard subject pools have limited application to environments in which the distribution of behavioral propensities is both endogenous and psychologically rare. This is the case in financial markets, which are subject to selection at a number of levels. Those who enter the profession are unlikely to be psychologically typical, and market conditions determine which behavioral propensities survive and thrive at any point in historical time.

If one is to look beyond economics for metaphors and models, why stop at psychology? For financial market behavior, a more appropriate discipline might be evolutionary ecology. This is not a new idea. Consider, for instance, this recent article in Nature. Or take a look at the chapter on "The Ecology of Markets" in Victor Niederhoffer's extraordinary memoir. Or study Hyman Minsky's financial instability hypothesis (discussed at some length in an earlier post), which depends explicitly on the assumption that aggressive financial practices are rapidly replicated during periods of stable growth, eventually becoming so widespread that systemic stability is put at risk. To my mind this reflects an ecological rather than psychological understanding of financial market behavior.