It's the Animal Spirits, Stupid!

In the midst of the financial panic sparked by the fall of Lehman Brothers, Alan Greenspan, chairman of the Federal Reserve from mid-1987 to 2006, shocked the American public. Testifying before the House Committee on Oversight and Government Reform on October 23, 2008, Greenspan had this extraordinary exchange with Representative Henry Waxman (see video here):

Do you feel that your ideology pushed you to make decisions that you wish you had not made?
— Rep. Henry Waxman
Well, remember that what an ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to—to exist, you need an ideology. The question is whether it is accurate or not. And what I’m saying to you is, yes, I found a flaw. I don’t know how significant or permanent it is, but I’ve been very distressed by that fact.
— Alan Greenspan

To many, Greenspan’s admission of a “flaw” in his ideology was a breathtaking indictment of financial deregulation. There was undoubtedly a complex network of villains who bore responsibility for the daisy chain of crises that spurred the Great Recession, but much of the blame rests with Greenspan's brand of free-market fundamentalism and, consequently, with Greenspan himself.

Alan Greenspan has long found economic regulation distasteful. During his tenure at the Fed, he actively sought to deregulate the banking and financial sectors of the US economy. This includes his opposition to regulate the relationship between commercial banks and securities firms, the subprime mortgage market, and over the counter derivatives.

Looking back on the damage such regulatory negligence has done, you would think the “flaw” Greenspan had identified in 2008 is now, five years on, obvious. So it may come as a surprise that he does not believe the Great Recession was caused by a failure to regulate what became extraordinarily risky practices—things like structured investment vehicles, “low-doc,” “no-doc,” and “liar” loans, collateralized debt obligations, and credit default swaps. Instead, he submits that his error was to underestimate animal spirits as economic forces, causing forecasters to miss the financial crisis entirely.

Lest you start wondering just what sort of animal Alan Greenspan is (he’s an owl, of course), know that he is using “animal spirits” in the Keynesian sense, to refer to the irrational elements of human psychology. Economic forecasters typically assume that humans are self-interested, rational money-maximizers, pursuing courses of action that result in the greatest long-term profit—a caricature of human behavior often called Homo economicus. The problem is that we consistently violate these assumptions.

In Greenspan’s recalibrated view, we respond inappropriately to risk (at times unreasonably risk averse, at others unreasonably risk prone) and are further propelled to extremes by “herd behavior,” driving markets into wild swings. Adding to our misery, we discount the future incorrectly, leaving us with little to no savings. All would have been fine, he assures us, had we been more like Homo economicus and less like Homo saps. The fault, dear reader, is not in our stars, but in ourselves.

As someone who has conducted research on the psychology of economic choices (see herehere, and here), I am sympathetic to the idea that policymakers have paid too little attention to the human mind. The silliness of the phrase “animal spirits” aside, there is a bustling, cross-disciplinary literature on the many departures we make from classical economic expectations, demonstrating that our behavior does not reflect principles of money-maximization or unmitigated self-interest. So, it is galling that an economist of Greenspan’s stature can comfortably admit, in 2013, to discovering (or appreciating) research that earned Daniel Kahneman and Vernon Smith the Nobel Prize in Economics more than a decade earlier. Economists have been studying the psychology of economic behavior for decades, and psychologists and sociologists for many decades more.

It might seem that by recognizing animal spirits as economic forces, Greenspan has aligned himself with behavioral economists like Janet Yellen, the newly minted chairwoman of the Fed, and her husband, Nobel laureate George Akerlof. Little could be further from the truth. Whereas Yellen and Akerlof believe our knowledge of animal spirits should shape regulatory policy, Greenspan believes it should merely transform economic forecasting. Animal spirits or no, Greenspan still trusts the markets to eventually right themselves. He only wishes we could better anticipate their toppling.

Sadly, as an answer to avoiding the next crisis, Greenspan’s faith in the next frontier of economic forecasting is misplaced. There is no doubt that people fail to pursue strict, monetary self-interest; thus, bubbles can grow rapidly and burst unexpectedly. But animal spirits did not cause the Great Recession. Indeed, people have never been more like Homo economicus than when they had access to unregulated markets. The years leading up to the bursting housing bubble were ones of skyrocketing property values, profitable investments, and minimal risk. Without regulatory oversight, bankers, investors, subprime mortgage underwriters, and their ilk pursued their winnings with abandon, convinced by the information available at the time that the only losing strategy was discretion. It was an era of striking prosperity with, to the best of anyone’s knowledge, no end in sight.

In a world where everyone has complete and accurate information about the value of an asset, the hypothesis of the efficient, self-correcting market in which Greenspan firmly believes will perhaps hold true. Perhaps. In the real world, however, where one party often has more information than others, or where no one has all the relevant information, unregulated markets may cause serious harm, even when every actor is the spitting image of Homo economicus. As the events that precipitated the Great Recession unfolded, we witnessed these informational problems with frightening clarity. Home-buyers, shareholders, and investors were uninformed or misinformed, yes, but so were bankers, brokers, traders, credit raters, CEOs, the shills who sold mortgages that were designed to default, and government regulatory officials. No one had all of the relevant details, not even “Maestro” Greenspan himself. This is what comes of stripping away the powers of regulation and oversight.

Alan Greenspan did not set the stage for the Great Recession on his own; he had considerable assistance from his fellow deregulators. So many of them, like Lawrence SummersPhil Gramm, and Robert Rubin, sat in positions of extraordinary power and mercilessly abused the public trust. There has long been evidence that markets are neither inherently efficient nor invariably self-correcting, but who were they to let the truth get in the way of a good story?

The worst animal spirit is not risk aversion or herd behavior. It is unwavering ideology.