Sunday, October 21, 2018

Book Reviews: 'Plunder and Blunder: The Rise and Fall of the Bubble Economy' by Dean Baker, 'Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism' by George A. Akerlof and Robert J. Shiller

Reviews by Susan Gardner
Plunder and Blunder: The Rise and Fall of the Bubble Economy 
By Dean Baker 
Polipoint Press, Sausalito, CA : January 2009 
170 pages, $15.95
Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism 
By George A. Akerlof and Robert J. Shiller 
Princeton University Press, Princeton, NJ: February 2009 
264 pages, $24.95

Clearly the dam has broken on a flood of new books aimed at explaining our dire economic straits. In the past few months, at least a couple dozen have landed on my front porch, most aimed at describing how we wound up here and how to get out of it. Two of the best (so far) are Dean Baker's Plunder and Blunder and George A. Akerlof's and Robert J. Shiller's Animal Spirits.
Baker's is an ideal, quick-sketch overview of the greedy, brain-dead policies and lack of regulation that landed us in the worst economic crisis since the Great Depression. As he notes, the details of the ridiculously arcane financial instruments that are emblematic of the high-risk era may be complicated, but the overall structure of the problem is not. First, we had an overrated stock market and then the money fled to the housing market, pumping that area up into the stratosphere. Pretending that these twin events struck out of nowhere is, he states, disingenuous:
The secret of these two bubbles is that there is no secret. Anyone with common sense, a grasp of simple arithmetic, and a willingness to stand up against the consensus could have figured out the basic story. The details of the accounting scandals in the stock bubble and convoluted financing stories in the housing bubble required some serious investigative work, but the bubbles themselves were there in plain sight for all to see.
While getting in some well-earned licks at the traditional financial media who should have been sounding alarm bells instead of acting as cheerleaders, Baker saves the bulk of the book for reprimanding the lack of disinterested, regulatory agents every step of the way in the investment and housing loan process. In particular, he looks at the corrupting role of those who are supposed to be offering up neutral valuations and assessments, from real estate loan appraisers to corporate auditors to bond-rating agencies, all of whom fell prey to giving bad advice ... because there was financial incentive to do so. Every one of these supposedly neutral parties, whether in the corporate advice realm (think Arthur Andersen) or loan appraisers, are rewarded by recruiting more loans, more approval of shady accounting tactics, more positive ratings on risky businesses through what the author rightly nails as "misplaced incentives."
Solution? Obvious, says Baker: "The first lesson to learn from the bubble economy is that we must set up the financial sector in order to give the proper incentives." Replace who appoints and who pays these auditors and advisors -- common sense dictates a separation between the party in a transaction who benefits from the outsider who evaluates. In the case of corporate auditors, he offers this solution:
The problem could have been easily addressed by taking the selection of an auditor out of the hands of the company being audited. One way to do this would be to have the stock exchange where a company is listed assign auditors randomly. Companies could then be allowed to refuse or replace auditors but only by presenting a public complaint. Even then, the company could be denied the chance to pick the replacement auditor.
He proffers the same advice for real estate appraisers, and in the case of bond-rating agencies, he suggests that there be requirements that raters be selected independently.
At the same time that Baker sees straightforward institutional changes that would guarantee that markets be operating in a more disinterested regulatory environment, he also urges readers to consider that there is more to life than financial incentives--and coming from an economist, it's good advice:
But finance is an intermediate good, not an end in itself. We might want more or better houses, health care, and food, but we have no reason to want more financial transactions. The fewer people and resources we need to do our banking, to provide insurance, and to meet our other financial needs, the better off we are. We want to structure the financial system to maximize its efficiency, not to drain the economy....
We have a seriously bloated financial sector that is absorbing an increasing share of the economy's resources. If a modest financial tax reduces the size of this sector, the workers who are no longer busy designing complex financial instruments might instead be engaged in more productive tasks, such as designing new software or fuel-efficient cars. Moreover, the revenues generated from a financial transactions tax can be used for many useful purposes, such as improving health care, education, public infrastructure, or even a progressive tax cut.
Baker's tallying up of the toll the economic sinkhole of Wall Street on the other sectors is sobering, and he faults not only the institutional players, but the other allegedly neutral and esteemed observers--the financial press and the ranks of economic commentariat:
... it was possible at the time to recognize these bubbles in time to avert them. A few of us did warn Americans about the likelihood of the problems we're facing now. We didn't have the same megaphone as a Federal Reserve Board chairman, a Treasury secretary or even a Washington Post columnist, so these warnings had relatively little impact. But it would be wrong to conclude, as many would have us believe now, that it was beyond our ability to predict or avert these market meltdowns.
Beneath all the surface complexity of our current mess lies a basic story--not only of institutional failure, but also of energetic self-deception. Grasping that story is the first step toward preventing the next economic calamity.
The "energetic self-deception" aspect of the recent bubbles, of course, is more difficult to measure and quantify despite its key role as foundation for all kinds of risk-taking. While Baker skillfully and succinctly gives a tour of the landscape that led to the current crash--and recognizes the role irrationality can play--he makes little attempt to explain it in depth. But Animal Spirits tackles the places that Baker only alludes to, stating flatly early on: "We will never really understand important economic events unless we confront the fact that their causes are largely mental in nature." These "mental in nature" causes are what economist John Maynard Keynes termed "animal spirits" and are not subject to the rules of empiricism.
Both authors are economics professors--Akerlof at UC Berkeley, Shiller at Yale--and they've chosen to take a closer look at the mystery of the role irrationality and psychology play in creating bubbles and recessions. Of primary import, they claim, are the narratives we tell ourselves about how the market works and what place we hold in it. A lot of what most participants instinctively believe is empirically true about how markets work--and about the nature of their predictability--turns out to be based on faith. Pure faith. This assertion, the authors admit, makes many economists more than a tad uncomfortable:
Most economists don't like these stories of psychological feedback. They consider them offensive to their core concept of human rationality. And they are dismissive for another reason: there are no standard ways to quantify the psychology of people. Most economists view the attempts that have been made thus far to quantify the feedbacks and incorporate them into macro models as too arbitrary, and thus they remain unconvinced.
After the past year or so of having seemingly well-informed financial analysts pimping tanking stocks, taking foolish risks and buying into the notions that stocks and real estate will forever rise in value ... well, it's refreshing to have the truth out there openly. Trust in currency, in promissory notes, in trying to figure out where the big money will invest next is really as reality-based as Greek mythology.
But the bounty of capitalism has at least one downside. It does not automatically produce what people really need; it produces what they think they need, and are willing to pay for. If they are willing to pay for real medicine, it will produce real medicine. But if they are also willing to pay for snake oil, it will produce snake oil.
The authors point to ebbs and flows of corruption scandals as taking mental tolls on investment practices, since they speak directly to the matters of faith and trust in financial institutions. After the deregulated heyday of the 1920s brought on a crash, the 1930s went back to regulation and policing since so much corruption was exposed. It was, for a time, the "national story" that businessmen were corrupt, that Wall Street if left to itself would take advantage of the little guy and that laws needed to be put on the books to keep the money men honest. As these laws proved to be effective over the years and corruption lessened (or was caught earlier and punished), a societal memory fade began to take hold and the reputation of financiers and their instruments recovered. After enough time passed, it seems that collectively we begin to feel the old urge to play a little faster, a little looser, take a few more risks and be ready to aim for a jackpot. And every generation or so, we forget the lessons learned by the previous crash -- or tell ourselves, "this time, it's different."
"The confidence of a nation, or of any large group, tends to revolve around stories," the authors write. "Of particular relevance are new era stories, those that purport to describe historic changes that will propel the economy into a brand new era." Once these stories take hold--and in our era, they do it faster than ever, given the reach of media and technology--the narratives themselves no longer are merely describing circumstances. Sometimes, to our detriment, they actually begin to create circumstances (faulty ones, at that, constructed on faith):
But what if stories themselves move markets? What if these stories of overexplanation have real effects? What if they themselves are a real part of how the economy functions? Then economists have gone overboard. The stories no longer merely explain the facts; they are the facts. To really explain Mexico in the 1970s, and indeed the ups and downs of most economies, one must look at the driving stories.
These stories, which like mythology, rise and fall in societies, are explored in depth by Shiller and Akerlof. Through economic questions, patterns are discerned as the authors tease out details that appear on first glance unrelated, but on second glance turn out to be deju vu all over again. The eight questions around which this exploration of mass psychology is structured are: Why do economies fall into Depression? Why do central bankers have power over the economy (insofar as they do)? The current financial crisis: What is to be done? Why are there people who cannot find a job? Why is there a trade-off between inflation and unemployment in the long run? Why is saving for the future so arbitrary? Why are financial prices and corporate investments so volatile? Why do real estate markets go through cycles? Why is there special poverty among minorities?
In a satisfying way, Baker's book and that of Akerlof and Shiller make perfect companion reads. With Baker, we get the rational explanation of what happened and why, and some common-sense practical regulatory and incentive solutions. With Animal Spirits, we hone in on how incentives and narratives can be created to channel the human psychological factor into collectively healthy directions, and how to be aware of the fictions we tell ourselves about how we wish the world and greed and financial security worked. Both books shed light on complex issues and leave readers with a better grasp of undercurrents and--most importantly--a rediscovered belief in principles of common sense and caution.

Editor's note: This review was originally published at the Daily Kos, which notes that its "content may be used for any purpose without explicit permission unless otherwise specified." The original page can be found here. Like what you read? Subscribe to the SFRB's free daily email notice so you can be up-to-date on our latest articles. Scroll up this page to the sign-up field on your right.