Finance in the 21st Century
Reviving the Animal Spirits
Robert J. Shiller
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NEW HAVEN – The world’s fundamental economic problem today is a staggering loss of business confidence. Commercial banks, investment banks, and hedge funds all owe their ongoing trouble to its decline, which in turn is jeopardizing the plans of companies and entrepreneurs to launch enterprises and make investments, and of households to consume.
Our “animal spirits,” to borrow a phrase made famous by John Maynard Keynes, are weakening. George Akerlof and I have just written a book by the same name, but by the time Animal Spirits appears later this winter, the world economy may be even worse than it is now.
Nations everywhere are starting to implement aggressive stimulus and bailout packages. Yet the economic outlook still looks grim. The International Monetary Fund’s latest forecast predicts that the world’s advanced economies will contract 0.3% in 2009 – the first such shrinkage since the end of World War II.
Part of the difficulty of contending with a crisis of confidence is that it is hard to quantify confidence in the first place. The Conference Board Consumer Confidence Index in the United States, begun in 1967, fell in October to its lowest value ever. The latest Nielsen Global Consumer Confidence Index, which covers 52 countries, fell to 84, from 137 when it was launched in 2005.
But these surveys, which tabulate quick answers to simple questions, do not tell us how deeply held these opinions are, how new circumstances might change confidence, or what people will really do when they make important decisions in coming months or years.
This decline in confidence is fundamentally related to the chaos in the financial markets that started in 2007 and accelerated this September. The specter of collapsing financial institutions around the world, and desperate government bailouts to try to save them, has created a general sense of alarm.
Then there is the effect of memory on today’s animal spirits. People know enough about the Great Depression to understand that there are parallels with today. Many know that interest rates on three-month US Treasury bills became slightly negative in September 2008 – for the first time since 1941. People are also aware that the stock market has not been this volatile since the Great Depression (with the single exception of October 1987). Beyond that, national leaders are defending extraordinary bailout measures by not-so-veiled comparisons to the Great Depression.
Animal spirits are not always shattered by extraordinary economic events. But then, not all economic convulsions are alike. For example, the October 19, 1987, stock market crash was the biggest one-day drop ever. The Standard & Poor’s Composite fell by 20.5%, the FTSE 100 by 12.2%, and the Nikkei 225 by 14.9% the next day. The crisis spread around the world, but there was no recession. Instead, world stock markets recovered, creating a colossal bubble that peaked 13 years later, in 2000.
In a survey that I conducted immediately after the 1987 crash, I found that the biggest concern expressed by individual and institutional investors in the US was essentially that the stock market had been overpriced. After the crash corrected that problem, many people apparently did not feel there was much more to worry about. The only parallel to the Great Depression was the stock market drop itself. Moreover, many financial experts blamed the 1987 crash on a kind of programmed trading called “portfolio insurance,” which most thought would stop.
But recent events do not carry such a rosy interpretation. The stunning magnitude of recent declines cannot be dismissed as a one-day anomaly caused by a technical trading glitch.
The week of October 3-10 was the worst stock market week in the US since the Great Depression, while Japan’s stock market performed worse than it did in the worst week of the Asian financial crisis ten years ago. Similarly, Mexico’s stock market performed about as badly as it did during the worst week of the Mexican financial crisis in 1995, and Argentina’s stock market roughly matched the worst weekly drop during the country’s financial crisis of 1997-2002. Extraordinary stock market volatility, both up and down, has continued since.
The current stimulus and bailout plans were hatched in reaction to that dreadful week. The G-7 countries announced a coordinated plan to fix the world economy on October 10, and that weekend the G-20 countries endorsed the plan. But stock markets were barely higher in early November. In China and India, they were lower.
The erosion of animal spirits feeds on itself. Immense market volatility serves only to reinforce people’s sense that something is really wrong. A volatility feedback loop begins: the more volatility, the more people feel they must pay attention to the market, and hence the more erratic their trades.
Perhaps the saving grace in this situation is that animal spirits can and sometimes do change direction. Confidence is a psychological phenomenon, and can make seemingly capricious jumps up as well as down. The most promising prospect for a return of business confidence now would be some kind of public inspiration. In the US, President-elect Barack Obama seems to have the charisma to create this, and his status as the first minority president marks a major historical transition that might have great positive psychological impact in the US and around the world.
Whatever the near future holds the multitude of plans now being discussed to deal with this global crisis need to be judged with attention to the elusive and inexplicable effects they might have on confidence. The “animal spirits” that Keynes identified generations ago remain with us today.
Robert J. Shiller is Professor of Economics at Yale University and Chief Economist at MacroMarkets LLC. His latest book is The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It.
Copyright: Project Syndicate, 2008.
www.project-syndicate.org
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tvselvakumaran 02:22 26 Dec 08
There are two economic situations where prolonged deflation could occur:
1. Globalization: In the last several centuries, there have been specific periods, each stretching up to several decades, when there were significantly increased flows of goods and services across national borders. During these times, the less developed countries had figured out how to produce goods that require older technologies efficiently. Hence, they could trade these goods at significantly lower prices. Also, improvements in transportation enabled the free trade of these goods. For example, the late 19th century was one such period. I quote from Professor Jeffry Frieden's Global Capitalism (p. 8), "From 1873 until 1896 prices dropped by 22 percent in the United Kingdom, 32 percent in the United States, more elsewhere. ... ... Prices and earnings declined but debt burden remained constant. Expectations of further price declines caused uncertainty and pessimism. More important, the price declines were not across the board. The prices of goods that entered readily into world trade fell particularly rapidly, such raw materials as wheat, cotton, and coal by 59, 58, and 57 percent respectively. But the prices of other goods and services fell more slowly or not at all. For example, American farm prices declined by more than a third, mining prices by nearly half, but construction costs stayed constant."
2. Depression: In a depression situation, due to severe miscommunication of price signals, the economy invariably goes into a chaotic condition. Firms lay off employees in large numbers expecting a severe downturn. The result is that consumers don't have the incomes necessary for purchasing goods. Inventories pile up and firms have to cut prices. However the more the firms cut prices the more is their losses, and they have to lay off more employees and reduce production. In the worst case, a quarter or a fifth of the working age population is unemployed. This cutting of production and prices and laying off employees leads to a downward spiral of contraction, deflation and unemployment, where these three factors reinforce each other. Thus there is a prolonged period of spiraling downwards, in particular a deflation in prices, before some external event puts an end to it. This was the situation in the Great Depression of the 1930s. During its worst phase, the GDP contracted by a third.
It is clear that the current economic crisis of 2008 would not lead to unemployment above 20%, nor a contraction of a third of GDP. Moreover, due to massive accumulations of capital, like social security and pension funds, consumers could continue to maintain their usual level of spending on essential goods even if they lose their jobs. Thus the re-appearance of a dire economic situation like the Great Depression cannot be cited as a reason for prolonged deflation in contemporary times.
Next, during the current phase of economic globalization, the phenomenon of 'China price' has been hitting the global economy since the 90s. These deflationary forces have been successfully managed so that there would not be severe destabilization of the global economy. This is the great contribution of Alan Greenspan, that he allowed the stock market to boom right into 2000, even though he worried about a bubble in the stock markets as early as 1996. China's supply of manufactured goods at low prices helped to keep inflation low, and enabled America to continue to grow with unemployment rates well below that specified by the Non-Accelerating Inflation Rate of Unemployment (NAIRU). On the demand side, the wealth effect created by the stock market boom enabled consumers to keep spending so that the economy could keep growing, which in turn allowed an increasing trade deficit with China. Thus Greenspan's stewardship ensured that America and China developed a stake in each other's well-being. Moreover, the case for globalization producing a prolonged period of deflation this time around is not compelling at all, since the resulting deflationary forces have been successfully managed for the last 15 years or so.
So why are several famous economists still warning against the dangers of a recurrence of the Great Depression? Depending on their preferences, these economists are either advocating inflationary monetary expansion, or huge fiscal spending to the extend that the budget deficit next year could be a trillion dollars. These are in addition to the massive expansion of the Federal Reserve's balance sheet (from $900 billion to $2.3 trillion so far), the $700 billion TARP program, and the large scale off-balance sheet programs announced by the Fed and the government for rescuing financial corporations and buying all kinds of securities.
Well, it appears that a consensus has been developing among economists in the advanced industrial economies that by enacting massive fiscal spending programs, they could re-engineer entire economies of the West so as to shift their focus on manufacturing and construction, and possibly away from services. As Professor Paul Krugman put it in his recent New York Times column, Life Without Bubbles, "By selling more to other countries and spending more of our own income on U.S.-produced goods, we could get to full employment without a boom in either consumption or investment spending". Other famous economists like Professor Robert Shiller, Professor Nouriel Roubini and Professor Joseph Stiglitz have written in expressing support for a massive fiscal spending program with the goal of maintaining full employment.
Well, there is some strength in this argument. Infrastructure is definitely crumbling in many parts of the United States. It would be appropriate to recall here that not long ago, a large bridge on an Interstate highway collapsed in Minnesota killing dozens of people. Schools, public libraries, courtrooms, police stations, airports, railway stations and other public buildings require upgrades urgently. Moreover, potholes have been springing on most public roads, and the local governments have only been doing patch-work on them for lack of funds. Similarly, the manufacturing industry has been languishing for several decades now. So there is definitely a case for upgrading infrastructure and reviving the manufacturing industry in the Western economies.
However, I should also point out that expending all the political capital that the left has won in the recent elections (for US President and US Congress) on a one trillion deficit spending program may not be the 'best bang for the buck' (to borrow Professor Stiglitz's lingo). At present, the most economic benefit that the United States can obtain is to recover its standing among the world nations by conducting its foreign policy with vastly improved diplomacy. In particular, spending the far less amount of $20 or $30 billion towards Millennial Development Goals and eradicating poverty would improve the goodwill for America around the world. As a result, America would obtain much better long-term economic benefits by spending just 2 or 3 percent of the trillion dollar deficit program.