Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism

  • George A. Akerlof &
  • Robert J. Shiller
Princeton University Press: 2009. 264 pp. £16.95 9780691142333 | ISBN: 978-0-6911-4233-3

Fool's Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe

  • Gillian Tett
Little, Brown: 2009. 352 pp. £18.99 141659857X 9781408701645 | ISBN: 1-416-59857-X
See online collection.

One of the unintended effects of the near-collapse of the world economy is the creation of a market for scientific advice to the banking sector. Senior officials at the Bank of England, for example, are consulting the theoretical ecologist and former Royal Society president Robert May, whose research interests include modelling ecosystem collapses and the spread of infectious diseases. Why? Because May's work could provide signposts on how to develop a comprehensive model for the movement of money around the world and the myriad connections between cash, individuals and institutions.

Two books highlight insights from other fields, such as psychology and anthropology, on the current global financial situation, and the damage done in the past by inappropriately applied mathematics. They also suggest that finance can learn even greater lessons from science, by taking account of the experiences of scientists and science's ideal of transparency and regulation.

In Animal Spirits, two Keynesian economists — George Akerlof, a Nobel-prizewinning economist at the University of California, Berkeley, and Robert Shiller, an economist at Yale University — use findings from psychology to amplify one of economist John Maynard Keynes's theories. In his signature 1936 work, The General Theory of Employment, Interest and Money, Keynes explained that economies should fluctuate because people behave in unpredictable ways — under the influence of what he called “animal spirits”.

Keynes's theory countered the mainstream view in economics that people, and therefore markets, behave in rational ways. But people often decide which house to buy or which car to drive because it 'feels right', or for other reasons that economists may find irrational or cannot measure accurately. Akerlof and Shiller remind us that emotional and intangible factors — such as confidence in institutions, illusions about the nature of money or a sense of being treated unfairly — can affect how people make decisions about borrowing, spending, saving and investing.

Animal Spirits is an affectionate tribute to the man whose ideas, unfashionable for the past 30 years, have resurged. Having advised governments through the Depression, Keynes became convinced that more government spending was needed to maintain employment during a recession — a prescription that has been adopted by many national leaders, including UK Prime Minister Gordon Brown and US President Barack Obama.

What Animal Spirits doesn't do is illustrate how descriptions of human behaviour can be used in quantitative financial and economic models. Bankers, analysts and policy-makers reading the book will want to know where they can find data on human behaviour, and how these data can be reduced to the indices, constants and variables that make up their equations. Akerlof and Shiller would have done well to have included a chapter covering this issue.

Insights from science have the potential to be misused, however. Gillian Tett's book Fool's Gold is an exceptional account of how today's financial world became in thrall to advanced mathematics. Tett, who runs the coverage of global markets for the Financial Times newspaper, came to journalism after taking a doctorate in social anthropology. Her book describes how a small group of young bankers with training in mathematics, physics and actuarial science created a class of financial products known as credit derivatives, the misuse of which helped to precipitate today's crisis.

Tett recounts how a group at J. P. Morgan, one of the United States' oldest commercial banks, came up with a scheme designed to free up more of the bank's capital for profit-making investment: selling the loans on their books to third-party buyers. The regulators were unsure whether this was allowed, but Tett shows how they were eventually won over following an aggressive lobbying campaign led by the bank.

Interestingly, J. P. Morgan decided not to shift bundles of mortgage loans in the same way as they were selling off commercial loans. This is because the bank did not have enough data to accurately predict the numbers of borrowers who would default, or the extent to which one defaulter might trigger others. Other banks, however, began to offer bundles of individual mortgages — including those given to 'sub-prime' clients. This practice was helped along by David Li, an actuarial scientist who published a formula that claimed to predict patterns of defaulting without needing data on individual financial histories. The market for sub-prime loan bundles went through the roof, and when these sub-prime borrowers began to default, the world economy went through the floor.

Tett concludes that banking needs to go back to an earlier philosophy: products should be simple to understand, bankers need to respect the fact that regulators are acting in the public interest, and regulators need to be more on the ball. This checklist sounds like the regulatory hurdles that many scientists have experience of — especially those working in areas such as food safety and environmental protection.

For example, after the bovine spongiform encephalopathy ('mad cow') epidemic and controversies over genetically modified crops in the 1990s, there was much soul-searching in Britain over how best to protect the public from possible future harm. One outcome was a new food-standards agency, independent of government and industry, to act in the interests of consumers. Many scientists were not enthusiastic about this change. But those who have worked in the system realize that good regulation and transparency are not enemies of progress.

The banking industry is waking up to the fact that advanced knowledge helped to create profits beyond imagination, but that greed and secrecy played a part in its near-downfall. Animal Spirits gives hope that such knowledge can be a force for good. Fool's Gold, meanwhile, reminds us that this must go hand-in-hand with transparency and keeping the public interest uppermost.