Reviving the Animal Spirits
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.