Forget macro, watch for ‘animal spirits’: Akerlof

While headlines highlight the unfolding debt crises in Europe and — eventually — the U.S., investors might want to take a much, much narrower view to improve their portfolio performance.

Rather than worrying about what might happen at the transnational level, they may be better served examining the motives of individuals, says George Akerlof, author of Animal Spirits and the Economy.

The book’s title is borrowed from economist John Maynard Keynes, who wrote in The General Theory of Employment, Interest and Money that non-economic motives often drive human behavior, including that of investors.

This flies in the face of the “perfect markets hypothesis,” which supposes that all decisions in a market are rational, Akerlof says. Given the “flash crash” of May 6, this theory might merit re-evaluation.

Economic cycles are best understood in psychological terms: They begin with confidence, which may or may not be well-founded. Either way, that confidence is an irrational suspension of suspicion, he argues,

As investor confidence rises, more capital is placed in the market. This attracts those players Akerlof calls “snake oil salesmen,” the ones hoping to make a fast buck off unsuspecting investors. That so-called snake oil has taken many forms in the past two decades, he says: Russian debt; Asian currencies; dot-com stocks; and most recently, real estate in the U.S. and Western Europe.

Inevitably, the snake oil industry goes bust, proving that investor confidence was undeserved, their trust irrational. The resulting stampede out of the marketplace is equally irrational, as quality investments are sold off in a quest for liquidity.

It ‘s up to governments to provide a stable regulatory framework to mitigate the animal spirits of market participants, Akerlof says, To date, that framework has been woefully inadequate, as witnessed by repeated boom-and-bust cycles.

The current push for tighter regulation in Europe and the U.S. is, therefore, the predictable response. It reverses the deregulation trend that began in the 1980s under the Reagan administration, which culminated in the deregulation of financial derivatives.

The crude deregulation of the past 30 years has been akin to letting toddlers out of their playpen, without bothering to watch them. The correct application of deregulation doesn’t disband regulatory agencies, but allows the derivatives to be employed, but with proper regulatory oversight.

Intervention Skeptics of government intervention — and they are legion — point to the bailout of the financial sector as proof that policymakers cannot be trusted with the public purse.

This criticism is ill-founded Akerlof says, noting that the Troubled Asset Relief Program’s (TARP) $700 billion price-tag has been mitigated by resales of assets by the government, and the repayment of emergency liquidity by several bailout beneficiaries. The true cost is closer to $350 billion, he says.

Was it well spent? Definitely, he says.

The TARP money caged the “animal spirits” of investors, who saw that the financial system of the western world would not be allowed to fail. Still, much of the public does not understand how they benefitted from the program.

Prior to the bailout, U.S. appeared to be on the brink of a second Great Depression. If the country had followed that path, Akerlof says unemployment would have been 25% for four years. Since the TARP money was deployed, unemployment has still gone up, but the scenario is less grim: he predicts that the U.S. will experience 10% unemployment for four years.

That difference is well worth the $350 billion cost, he says, and the government should continue its deficit spending so long as it supports employment growth.

(06/09/10)