Professors Akerlof and Shiller, in their letter about my review of their book, attribute to me (by implication) views quite different from what I hold. Perhaps I didn’t explain myself clearly enough in my review. I have set forth my views at length in my book A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression, but it was published just a couple of weeks ago and I am sure Akerlof and Shiller haven’t seen it--for which obviously they cannot be criticized.
I’ll explain where I think they have my views wrong, but let me first note a rather remarkable concession in their letter. I had argued at some length in the review that they have misunderstood Keynes; that the “animal spirits” that they think are responsible for bubbles (which lead to busts, such as the huge one we’re in) need to be dampened, whereas in fact Keynes believed that animal spirits had to be encouraged, because they were the key to lifting an economy out of depression. Because businessmen, especially when investing in projects that will not yield an immediate return, are operating in an environment of uncertainty (that is, of risks that cannot be calculated), they need a spurt of confidence--a willingness to take a shot in the dark--a plunge into a body of cold economic water--in order to steel themselves to invest. Their confidence and hence willingness to invest, and the confidence of workers and hence their willingness to spend, are diminished when unemployment is high. So, Keynes argued, government should step in and replace lost private demand for goods and services with increased public demand (for example, new roads). That will increase the willingness of businessmen to hire and invest, and by reducing unemployment, it will increase the willingness and ability of workers to spend.
Rather than defend their interpretation of Keynes, Akerlof and Shiller say in their letter that “we cannot say definitely to what degree Keynes would have been sympathetic to our view. Nor does it really matter what he would have thought. We are presenting a theory of macroeconomics which we think is in the spirit of Keynes, but it is a new theory” (emphasis added).
That is not how they discussed Keynes in their book. They ascribed to him the claim central to their own analysis that “these animal spirits are the main cause for why the economy fluctuates as it does. They are also the main cause of involuntary employment. … Keynes’s animal spirits are the keynote to a different view of the economy--a view that explains the underlying instabilities of capitalism” (footnote omitted; emphasis in original).
The irony is that the authors rightly criticize mainstream economists for having so far forgotten Keynes that present-day “Keynesian economics” bears little relation to Keynes’s actual views. It seems that Akerlof and Shiller are among the forgetful ones. This is surprising because Keynes is a powerful antidote to the kind of overformalized mainstream macroeconomics that they criticize.
With much of their letter, nevertheless, I agree. For much of it is devoted to criticizing the mainstream macroeconomists for being clueless about conditions that can give rise to the kind of economic crisis that we are in and about how to get out of it other than by doing nothing and letting nature takes its course, as it were. But they seem to think that I am one of those mainstreamers who believe that “people are like computers” and as a result that “speculative markets are perfectly efficient and prices change through time only as a result of objective new information.” They assimilate me to those economists (actually I am not a professional economist, and until the banking collapse last September, I was barely aware of the conventional academic thinking about macroeconomics that Akerlof and Shiller rightly denounce) who “denied that bubbles even exist” and, like Greenspan, believed “that the stock market was soaring [in the early 2000s] because economic actors must [have been] foreseeing a dramatic new economic era.”
I don’t believe any of these things except the last (that “new era” expectations, as Shiller himself has argued, can power a stock market bubble), as I thought I sufficiently indicated in the review but maybe I was too terse. It is because of the environment of uncertainty in which businessmen operate that “animal spirits” play a critical role in investment decisions. It is why the harassment (albeit as yet mainly verbal) of business that is becoming a hallmark of the Obama administration’s response to the continuing economic crisis is unsound from a depression-fighting standpoint. It dampens the animal spirits. Harassment deepens the uncertainty of the business environment.
I do not disbelieve in bubbles, and in my book I criticize Greenspan for failing to prick the housing and credit bubbles that, bursting only when they had attained enormous dimensions, brought the economy low. But where I differ from Akerlof and Shiller is in being more hesitant than they to seek an explanation for bubbles and other features of the business cycle in such ill-defined and miscellaneous concepts as (to quote from their letter) “variations in the level of trust,” “storytelling and human interest,” “perceptions of corruption or unfairness,” “anger and optimism,” and “social epidemics causing changes in gut instincts and feelings.”
What happened to Occam’s Razor? Do we really need such an assortment of “inconstancies of human thinking,” in their term, to understand how an investment bubble forms? How about the following explanation for the housing bubble?--it has at least the virtue of simplicity. In late 2000 the Federal Reserve under Greenspan pushed down interest rates and kept them very far down for several years. Interest rates and housing starts are negatively correlated, because houses are bought mainly with debt (for example, an 80 percent 30–year mortgage). So when interest rates plunged, housing starts soared. But because the housing stock is highly durable, a surge in demand for houses, fueled by very low interest rates, causes the prices of existing houses to rise (an increase in demand will cause prices to rise if, as in the case of housing, supply is inelastic; that is, expands only slowly in response to rising prices). Seeing house prices rise, and being assured by economists and officials (such as Bernanke) that they were rising because of economic “fundamentals” rather than because of very low interest rates that could not be sustained indefinitely, demand for houses, and therefore for mortgage financing, rose. When the Federal Reserve finally began pushing interest rates up because of fear of inflation, house prices leveled off and soon began to plummet because many house purchases had been based on an expectation that prices would continue to rise. The banking industry, heavily invested in housing as it was, was dragged down with the collapsing housing market.
In this analysis, the housing bubble was a product of unsound monetary policy rather than of irrationality. That the bubble resulted in the near collapse of the banking industry was, I argue in my book, due largely to a combination of the low interest rates, which magnified the inherent riskiness of banking, and the deregulation movement, which allowed bankers to indulge their rational, but from an economy-wide perspective dangerous, appetite for risky lending. That appetite is rational because risk and return in finance are positively correlated and because businessmen rationally worry about the consequences of bankruptcy for their own businesses, but not about the consequences for the economy as a whole--worry about those consequences is a responsibility of government, which government shirked until too late.
People have different levels of aversion to risk. Some are born gamblers, and are drawn to finance because of the positive correlation of risk and return that I mentioned. Some born gamblers are homebuyers rather than financiers and decide to buy a house in circumstances where if prices fall their investment will be wiped out. Nothing is gained by calling such businessmen or such consumers irrational. No doubt fraud, conflicts of interest, misunderstanding of complex transactions, dumb mistakes, and other human failings were features of the housing and credit bubbles and ensuing collapse. But these are constants in human behavior and cannot explain a (we hope) once-in-a-lifetime economic catastrophe.
Richard A. Posner is a judge on the U.S. Court of Appeals for the Seventh Circuit and a senior lecturer at the University of Chicago Law School.
By Richard A. Posner