Animal Spirits, Part 4

Robert Shiller's new book, "Animal Spirits," is out, and he has used the occasion to offer some more thoughts about the economic crisis. Link here.

Following Keynes, Shiller states that since investors cannot know with certainty the return on their investments, they are basing their decisions, not on rational calculations, but on animal spirits. To which Shiller adds, on stories.

In a poorly written sentence Shiller explains: "People's economic moods are largely based on the stories people tell themselves and tell each other that are related to the economy."

The tech bubble was kept inflated because people wanted to live the stories of dotcom millionaires. Then they wanted to live the stories of house flippers. Then they rushed into the securitized mortgage market because smart people were getting rich there.

Surely, some people live their lives as though they were stories. Often these end badly.

But that does not mean that stories are a primary motivating factor in human behavior. It means that some people some times allow themselves to get caught up in irrational exuberance.

Paradoxically, people are drawn to live out stories because the outcome is predetermined. Nothing you do can change the ending of the movie you are going to watch tonight. Seeing life within the context of a story allows you to imagine that you can remove all uncertainty.

Markets, however, do not function as stories. They function as games.

People play games because they want to compete and participate, and because they believe they can succeed. People drove up the prices of tech stocks because that was the biggest game in town at the time. Idem for mortgage backed securities.

Everyone wants to be actively involved in games; they are not primarily motivated by a wish to make themselves into living fiction.

Games and stories differ fundamentally. The outcome of tomorrow's ballgame is not predetermined... or, shall I say, it had best not be. With a game, when you cheer or jeer from the stands, you are trying to influence an indeterminate outcome. You are part of the team, not an actor in a drama.

Let us correct Shiller, and say that free enterprise is a game. Government has a place in this game, as an umpire and a referee. Government does not counterbalance a human tendency to pillage; it allows human beings to play the game the way they want it to be played, fairly and justly.

Attacks on unfettered free market capitalism are attacks on a straw man. There is no such thing as a market where there are no rules and no enforcement of the rules and no one entrusted to ensure fairness.

The issue is whether government can encourage everyone to play by the rules, or whether it wants to determine the outcomes. Because, after all, some outcomes make for better stories.

When the government tilts the game in one direction or even decides that it must determine the outcome, smart people will withdraw from the game.

They do not want to expend their animal spirits on a game that is rigged, that has been turned into a story with a predetermined ending.

Of course, rigging the game is not merely the province of government. Government can also sit by and allow others to tilt the playing field to their advantage.

Recently, too many people decided that they could leverage their bets to an absurd level because they believed that the game was rigged and the fix was in.

If you believe that the game is rigged, and you believe you are betting on a sure winner, then you will happily bet your house on the outcome. Isn't that what happened to the financial system.

The system was not rigged by crooks and thieves, but by people who suffered hubris about their own genius. Brilliant minds decided that the game was being controlled by invisible forces, and that they were smart enough to figure out the outcome in advance.

Thus, they could confidently bet their houses, and our houses too.

So, stories can motivate people, but only at the extremes, when they believe that the game has been fixed.

If there was an unseemly rush into the markets because too many people believed that they could never fail, now there seems to be a rush to the exits because many people believe that with the government picking winners and losers, there is no way to ensure that the game is going to be played fairly.