Where Robert Shiller Goes Wrong

Robert Shiller and George Akerlof have been winning accolades for their book "Animal Spirits" which argues that classical economics portrays a false view of the market as rational. In their view, a fuller account of markets would incorporate the insights of behavioral economics. More specifically, it would accept that non-rational, animal spirits influence behavior.

As far as this goes, there should be little argument. People are often wrong about what will make them happy, they stubbornly cling to the status quo, they become fearful or exhuberant beyond warrant, they over-value education and they insist on watching American Idol. They attempt to explain the world in stories that sometimes overly simplify complex realities, and these just-so stories then influence their behavior.

Where Schiller and Akerlof go wrong is thinking that the role of animal spririts in the economy justifies a broad role for government regulation of markets. And, ironically, they make this error because they ignore their own insights about human behavior.

The claim that a world of animal spirits justifies government regulation rests on the tacit assumption that animal spirits stop at the government’s doorstep. But this assumption is unjustified. There is no reason to expect that the kind of biases, errors, enthusiasms, fears or mythological thinking that Shiller and Akerlof think characterize markets do not also characterize governments. To the contrary, animal spirits are likely to be even more of a problem for government since there is less room for a correction. Markets fail when they become too far removed from reality; governments tend to fail upward, with each failure providing a justification for broader government powers. Markets have built in checks that government regulation does not.

What really seems to have gone wrong in Shiller and Akerlof’s analysis is a failure to appreciate the strength of their own discovery of irrational behavior. Or, to put it differently, they’ve applied a double standard that applies behavoiral economics to market actors but imagines a rational and benevolent regulator. Their view of regulation is just a mirror image of the shallow view they say classical economics takes on markets.

In short, Shiller and Akerlof provide a good starting point for thinking about animal spirits but they don’t go far enough. To paraphrase a certain literary prince, it’s animal spirits all the way down and all the way up.