This book importantly contributes to finance and economics by analyzing human behavior. With analyzing human behavior, “animal spirits” term is presented. This means that people are not rational in every economy when they decide. Economies are directed by animal spirits. For example, panics or confidence have big importance for economy. Animal spirits are contrary to supporter of followers of completely economic interests and perfectly competition markets. Aim of this book is to explain how animal spirits affects economy and why they are important for world economies. Authors emphasizes current global crisis together with animal spirits since they think that current crisis resulted from animal spirits. Also, they gives many experimental examples and facts that illustrates animal spirits
The book is divided into two parts. In first part, animal spirits are introduced and they are analyzed how they have effects in all economies. These animal spirits are confidence, fairness, corruption, money illusion and stories. In second part, some economic theories and current situations are examined by these five animal spirits.
Firstly, it is mentioned that confidence is very important concept for economies. It is based on foresight of future. When people have confidence, they become optimist and behave with irrational ways. In contrast, they are pessimist if they have lack of confidence. Also, confidence is affected by society. In a society, if there is a general confidence environment, others who cannot understand economy follows confidence environment. This creates optimism about future. Confident markets are bull markets. That is, since people are confident, their economic behaviors are with same positive way. In contrast, when they are not confident, markets are bear markets. Pessimism level is highly important. Panic and crisis even are stemmed from pessimism. A feature of confidence is irrationality. If people have confidence, they didn’t think enough with detailed way. Confidence environment is enough to make decisions. That is, they are irrational. Moreover, it is emphasized that confidence level directs GNP and move directly proportional. Their correlations can be measured by confidence indexes. This measures that changes in confidence level will be forward indicator of GNP and even confidence because consumers behave according to confidence and it will affect income and investment so new GNP will reflect confidence. After new GNP, confidence level will renew itself with respect to GNP numbers.
Secondly, fairness have important role in economic relations among people. Although traditional economics theory doesn’t care about fairness, it arranges goods and services prices, wages and salaries. In fact, prices are determined with respect to it. For example, price theory explains that prices should increase if there is an excess demand. But it is not easy because people comment this as opportunist attitude and doesn’t think fair. People usually want to find right and fairly make decision so it is invisible side of economy. So determiner of prices and wages mostly take into account fairness.
Thirdly, people are affected by corruptions in an economy. Corruptions such as accounting and credit fraud lead to market distortions and to even long term crisis. Primarily, this is stemmed from presence of limited companies. Since limited companies give limited responsibility and limited losses in situations of losses, managers make risky decisions and fraud so losses from these enterprises cause crises because stock investors are aware of situations of company after scandals. Also, people and governments have trouble in corruptions stemmed from credit firms such as Savings and Loan Institutions because these institutions make deposits from public resources and guarantee from government budget in case of losses. In short times ago, there were big three crisis including corruptions. These are Savings and Loans Institutions in 1991, Enron in 2001 and Subprime Mortgage Crisis in 2007. As results of these crises, corruptions substantially affected investor behaviors and so markets. Corruptions after Savings and Loans Institutions which give mortgage credits lead to decreasing prices in mortgage and markets. Also, After Enron scandal, investors escaped from financial markets. Generally, if markets faced with any corruption, this situation simultaneously affects financial markets and related sectors.
Fourthly, another animal spirit which affects investor behavior is money illusion. Money illusion means that investors behave differently from real values. That is, they tend to decide with respect to nominal values. And pricing and cost of goods is determined by nominal values. People have money illusion because of inflation. That is, people don’t take into account inflation in daily transactions. Inflation effect is hidden and invisible so wages contract, debt contract, and accounting interacts with inflation and its effects to money illusion. In wages contract, money illusion is related to COST (Cost of Living Adjustment) which means “automatic adjustment for inflation”. Labour unions don’t take into account COST even if inflation is higher when they bargain wages. And many new contracts don’t reflect inflation expectation. In debt contract, bond and mortgage credits are often adjusted fixed rate. They don’t simultaneously change with inflation so these rates remain unchanged if inflation rate and expectation change. In accounting contract, accounting transactions reflect business performance. If transactions reflect only nominal values and don’t reflect inflation accounting, numbers may be deceptive. That is, account transactions also can include money illusion.
Finally, telling stories is important psychological factor for economy. Psychologically if stories told increases in a speech, people have closer relationships and these stories strengthen existent relationships. And neurologically it becomes permanent in memory if stories in brain are told more. Stories are everywhere, even in economy. As similarly, stories have also big role over economy. Stories in economy tend to be herd behavior. Telling or creating a new story and/or exaggerate current story directs markets with respect to importance of story so social media and environment of financial market such as brokerage firms are significant part of stories. Moreover, confidence and stories have close relationships. Creating new story or exaggerating story is beneficial in order to build confidence environment. People buy or sell in market with respect to information stemmed from stories. That is, if a market consists of positive/bullish stories, people consume and invest more. For example, if a country like Turkey grows up while many countries are troubled with recession, markets creates and direct positive stories about future. In contrary, people hold their cash and forgo their investment if pessimist stories are spread. For example, if a sector is troubled or not profitable, stories related to this sector become damaging this sector so investors don’t invest this sector. In briefly, stories interact with confidence and herd behavior with respect to kind of information.
In book, there are six vital subject related to these animal spirits. These are big crisis, power of central bank, unemployment, a tradeoff between inflation and unemployment, savings plan and volatility of financial prices and corporate investments.
Firstly, two big depressions are explained by animal spirits. Firstly, 1890 depression crisis based on people’ panic behavior. In briefly, Panic behavior was derived from “Silver Purchase Act of 1890”. Because of this act, people thought that banknotes would decrease their values so they suddenly withdrew their money from banks. In fact, this crisis began with story animal spirit. They faced with important crisis in 1873 and 1884. They thought that this crisis expanded with parallel way like 1873 and 1884. And they remembered past experience and stories. Then, markets lost confidence environment based on remembering stories. Thus, people were in queue to withdraw deposits. After withdrawing deposits from banks, interest rates went up so many firms faced with bankruptcy. After stories and following confidence losses, markets were in crisis and affected private sector. Wholesale price indexes decreased, employer wanted to reflect decrease to their employee. But it was not easy with respect to fairness animal spirit. Because of disagreement in wages employees left their jobs. That is, applying rational wages theory was impossible. Instead of, fairness sense controlled markets. And there was a money illusion in this situation. Although wholesale price indexes decreases importantly and affected prices, employee couldn’t comprehend. Also, some frauds occurred together with starting crisis. That is, there were corruptions. In summarily, after an animal spirit which was story initiated crisis, others animal spirit including confidence, fairness, money illusion and corruption followed this through crisis. Secondly, 1930 big depression stemmed from overheating economies in 1920s. Overheating economy means that people have overconfidence and big growth expectations about future with respect to animal spirits theory. In this terms, people consume more and unnecessarily, and invest inefficiently. Briefly these years are qualified as years of high social welfare and stock markets were influenced so they had boom. Markets were like rally and were increasing consistently based on stories and confidence spirits. However, this rally terminated with second big depression and there were collapsed markets instead confidence environment. This depression stemmed from collapse in stock market and banking crisis with respect to rational economic theory. However, there were animal spirits deepening recession, that is, transformed into depression. These were fairness, money illusion and confidence. Employer had trouble with fairness sense like 1890 crisis although there was big depression. Employee still didn’t comprehend nominal and real values in discounts. Normally, there was a no problem in wages discounts if markets faced with big price decreases but they want to have labor right. Additional to fairness, changes deflation rate and wages rate show money illusions. That is, although there were no real changes in wages based on deflation, employers comprehended it as real. Also, there were losses of confidence among depression. After financial market collapses, people don’t consume and invest unlike 1920s confidence. These situations deemed crisis.
Secondly, Central Banks have important strength over markets. They interfere economy with monetary policy. They have two methods to affect monetary policy. These are open market transactions and rediscounting credits. Generally they benefit from open market transactions because rediscounting credits are only related to troubled banks. With open market transactions, main tool is interest rate because they buy and sell bond in order to money supply and demand. Their roles are vital because changes in money supply leads to changes to interest rate. And changes in asset prices are stemmed from changes in interest rate. That is, asset values are influenced by interest rate, and this also leads to changes in people’s income. However, their roles are narrow. In recession times, interest rates are altered with limited rates. For example, Central Banks are unsuccessful in order to decrease rates below zero. Instead of this, central bank should have different aim. With respect to this, central banks should be latest rescuer and intervener in order to be successful. And FED carried out in example of Bear and Sterns. Instead of bankruptcy of Bear Sterns, FED help to JP Morgan Chase acquire Bear and Sterns in order not to affect all markets. Because markets are integrated, bankruptcy of Bear and Sterns would influence market confidence. And depending to this, people had negative stories and confidence.
Thirdly, wages theory is compared by efficient wages theory (traditional) and animal spirits theory. Although efficiency wage theory often focuses on prices, animal spirit theory explains unemployment with fairness which is animal spirit. Efficiency wage theory states that efficiency of labor depends on prices. Additional to this, unemployment is determined by labour supply and demand with wages. If there is excess supply of labor, people who are more compatible to wages and other things are employed. That is, unemployment rate will be higher if excess supply of labor is more than excess demand. Also, they are laid off if they slack their job and they don’t be unemployed if they work harder according to Stiglitz and Saphiro. However, this is not such easy in real labor markets because these approaches are insensitive to human and workforce psychology. According to fairness animal spirits, wages are important and employees demand more wages if unemployment is lower. However, other factors also have important role in labor markets. Besides wages, employees want to be fair employer’s attitude. That is, they follow their right. If there is a lack of justice, it leads to important business problems. In contrast, if employers present claps of success to motivate employees, they will be more faithful and this leads to more efficient employees.
Fourthly, there is a reverse relation between inflation and unemployment. If zero inflation is targeted, policy makers agree more unemployment rate. Technically, Philips Curve reflects this correlation. Moreover, there is a tradeoff between them with respect to statistics. That is, people sometimes agree with inflation because of this trade off. However, important thing is money illusion and fairness between wages theory and inflation. According to animal spirit theory, people take into account only wages in situations of lower inflation. Employees don’t comprehend two factors in wages-inflation relationships. Firstly, employees never agree with wages cut even if there is big deflation like 1930 big depression. Also, according to fairness animal spirit, employers avoid wages cut in order not to affect employee’s efficiency because they work more aggressively. That is, as mentioned that money illusion and fairness interact. Secondly, they don’t realize relationship between more wages and higher inflation. If wages increases with lower rates in comparison of inflation, they think that their welfare will be more than current welfare. Also, labour unions take into account more wage increases if inflation is higher than normal. That is, if inflation increases abnormally, then they only think inflation effects and their welfare For example if there is a small inflation rate such as 3%, people are more happy about their employers for wages increases even if wages increases is 2%.
Moreover, savings plan are differentiated with respect to people arbitrary and differences among cultures. Many people don’t consider future and consume daily when savings plan is arbitrary. That is, they are unsuccessful in order to determine retirement plans. Credit cards encourage consuming and also people consume more than their needs. Therefore, government should interfere savings and retirement plans. There are two model cases and effects of animal spirits as example. Firstly, Singapore were successful with “Save More Campaign” and reached about 50% savings rate which is great rate by encouraging people to save more. Singapore was model for China. Like Singapore, China also accomplished with “Save More Campaign”. Reason of success is clear. Instead of individualism, social policies create herd behavior with following others and common confidence to success. Also, stories about Singapore success have effects over Chinese saving plan. These programs which animal spirits have important role brought success, especially to China. And higher savings rate became engine of growth. In contrast, all savings plan are arbitrary and there is no intervention of government to savings in USA so people are consumption crazy through credit cards. Accordingly, savings and retirement plan of different cultures are shaped through plans.
Finally, financial markets face with fluctuations in daily transactions. They are affected by mostly animal spirits. Firstly, financial markets increases and decreases depend on human psychology. If markets have bullish trend, people reacts this with buying stock. In contrast, if markets have bear markets, they sell their current positions. This is referred technically to feedback which means that “people react in same direction to past prices changes” according to authors. Feedback is important human behavior to affect all prices. This effect even leads to crisis because of it may create bubbles in stocks and assets. Also, this has importantly influences among markets. Thus, results from feedback create domino effect in markets. For example, stock exchange market or house prices increases with feedback effects. After prices raises, markets are dominated by another animal spirit, confidence. With confidence, people consume more. Economy faced with overheating trouble. After ceiling in prices, markets become reversed and move down. Together with decreasing prices, mortgages prices are also affected. People have problems because of repayment debt to banks so banks reduce credits, stops to finance projects and cannot fortify private sector with their finance. In briefly, only feedback effect in people can affect all markets. An important reason of current mortgage crisis stemmed from feedback. After housing prices boomed because of feedback and confidence about future, bubbles depend on increases collapsed with declining prices. Additional to feedback effect, petroleum market volatility are important because of correlation with other markets. Petroleum prices boomed in 1974 and 1979. These changes were originated from all speculations. Both extraordinary changes also derived from animal spirits. Negative stories about petroleum which contained scenario of boomed populations and scarcity of natural resources were spread among all markets. Secondly, corporate investments are mirror of total production because corporations direct future economic power of country. According to traditional theory, they invest depending on capital budgeting such as expected cash flows. In fact, these investments depend on management psychology and social psychology. Future is uncertain so they make decisions with irrational ways. That is, their investment decisions are intuitive instead of logic. Also, social psychology has influences over company because many decisions are made by board of director and department managers.
As a result, Animal Spirits which are confidence, fairness, corruption, money illusion and stories have big role over economy. Akerlof and Shiller exhibits that animal spirits are
invisible and markets are directed by them. Also, they are related to many subjects from unemployment to monetary policy. Economists should study them instead of explaining economy with incomprehensible
