I like the book "Animal Spirits" quite a bit and thought it might be worth my while to take this generalist economics text and see if I can do some thinking around its contents. The book was written by Shiller and Akerlof around the time of the immediate aftermath of the great recession of 2009.
There are no mathematical equations in this book, and he attacks Friedman on a few key points. Shiller is of course a Nobel prize-winning economist also, whose research into measuring cycles in housing and equity markets and whose criticism of the efficient markets hypothesis have made him justifiably praised.
I'd like to start by saying a few things about the left-right approach to economics and how this relates to mathematics. One can trace through Keynes, Hicks, Tobin, Samuelson a strong line of economic reasoning with mathematical modelling. Likewise with the work of Friedman, and the neo-liberal school. But ever since Keynes there have been elements of the traditional story which operate beyond mathematical modelling. Primarily of course was his idea of animal spirits, the subject of Shiller's book.
By analogy, there is the story of the elaboration of the theory of option pricing. Great advances were made when stochastic modelling was applied to the problem of the price of a call option. The mathematical model was able to express randomness sufficiently well to give birth to a whole branch of economics, and to enable a host of trading strategies.
In time, modellers of options realised that they could produce better models than the Black-Scholes, with its assumption of constant volatility over the life of the option. These models included the possibility that the level of volatility itself, during the life of the option, might move around, and perhaps even jump in a discontinuous way. These later models are preferred by many vol traders.
I can imagine in time a similar broadening of the mathematical models of the macro-economy to allow for modelling of what we now call animal spirits. The phrase itself points to human psychology as a source of wisdom about the source of certain cycle-inducing phenomena which recur in many modern economies. Indeed Shiller's book takes inspiration from Kahneman and Tversky. But before I go through that, I'd like to point out that this does not mean we ought to abandon the possibility of finding and modelling animal spirits mathematically. This is no inherent contradiction. Indeed, options trading itself can be driven by psychology and yet the theory of option pricing proposed so brilliantly by Black clearly enhanced our understanding of the subject and also partly structures those markets.
Keynes in his General Theory used the phrase to describe an absence in his model, the absence of a coherent explanation or model for why businesses so frequently and so comprehensively change their mind on the level of desired business investment. Shiller also widens this analysis to many more actors - to consumers, to central bankers, to economists even, and to market participants.
He also elaborates on the primary dimensions, the pathways of expression of the idea of animal spirits: confidence, fairness, corruption and bad faith, money illusion and stories. Through these pathways do animal spirits exert themselves. Through these pathways also, I suggest, can stochastic models be built; though he does not do it in the book.
I'd like to spend some time on categorising and distilling these five animal spirits. Four of the five are themselves expressed in cyclical ways, only money illusion is, so to speak, cycle agnostic - our human capacity to perceive and act upon real prices rather than nominal ones, our inability to cope with inflation, seems to be permanent. Yet of course this blind spot can hurt us more at certain points in the cycle. Indeed it could be argued that all five psychological dispositions, or weaknesses, in a sense, are permanent features of the human psyche, and that would be true; but as a business cycle evolves, we clearly express these four traits more and less fully, whereas with inflation-blindness, we appear to more or less continually fail to see it. Clearly, in times when we have high inflation and expected high inflation, money illusion could have a tendency to do more damage to us, which might paradoxically lead us to then pay attention to it; conversely we may worry less about it in low inflation environments, hence any longer term model of markets might be more susceptible to this blindness.
Also I see fairness and corruption/bad faith as two sides of the same coin. I also see stories (our incredible sensitivity to story telling as communication) as a vector of transmission rather than an animal spirit itself.
Confidence can these days be somewhat measured. Central banks can ask questions of the relevant actors, and these responses can be transformed into indices, which can then act as independent variables in more or less complex modelling frameworks for our location on the business cycle. It also underpins in essence , all the other animal spirits of Shiller's book. In a way, one could consider reports of fairness or reports of bad faith as merely adjunct mechanisms to measure confidence, as it is expressed through collective stories.
In other words there seems to be a single primary source of energy, capable of being expressed in an official central bank or governmental confidence measure, capable also of showing up in stories, both directly expressing the ebullience of the age and indirectly, reflecting on scandals of fairness, scandals of corruption and bad faith.
Money illusion, then, acts like the original Keynesian multiplier - it acts as a form of leverage. When we are looking forwards and backwards in a world of cycles, we fail to properly compute the fair value of various modelling elements. This, like the amplifying effect of the presence or absence of the spending multiplier, will make cycles more extreme, and perhaps also last longer.
At a rough approximation, business cycles are determined somewhat in the rear view mirror, and are largely bounded by and reset at the time of a recession. This starts the clock ticking again, and the economy ventures haltingly higher, until another reset event happens. The more relevant mathematical model for this is to model recessions as events in a Poisson process, where perhaps the $\lambda$ parameter isn't constant.
This one could call 'ground zero' cycle modelling. You're modelling the moment that the clock gets reset. I personally like this as it is simple. However, there are other approaches. For example, you can model phases of the cycle - for example break up the cycle into four periods, then work out the probability that you are in any one of those periods.
I think the virtue of these models is that it is quite likely that e.g. factor premia vary by phase of the business cycle. If you modelled it as a Poisson process for recessions, then you'd be having to build out some kind of time-based prediction of which phase of the business cycle you were in already.
If I were to insist on modelling the cycle as a Poisson process, then there would be some form of cyclical element which controlled the $\lambda$ parameter. That time-based parameter would in effect be a model of confidence.
Ideally you'd be looking to process news stories, count word frequencies, etc, to build a model of reported confidence, reported fairness, reported corruption and bad faith. Again, money illusion is presumed to be constant (if anything it ought to be waning as people become more familiar with it, though that seem not to be happening; it certainly isn't getting worse on a secular basis).
The political message from the Shiller book, in direct opposition to the neo-liberal school, is that capitalism cannot self-police. Friedman had a lot more confidence that it could. And the von Mises-Hayek Austrian school perhaps goes one better - perhaps they're also prepared to admit that cycles are real risks but they think that the periodic devastation is best left to play out, with no or minimal government intervention or massaging of the economy. This question is the essence of the modern politics of left and right. And behind it is the practical experience of recessions, their frequency, their solubility, their desirability. It is in a sense the primary question of macroeconomics and one which economists appear not to have reached agreement on, which means it is not a trivial problem.
Imagine a world were the business cycle was tamed somehow. Risk would be taken out of the markets. In the limit, the risk premium of the equity market would drop towards the real rate - investors would not demand to be rewarded as much for taking smaller risks. If company returns in aggregate were more like a safe bet, then we would be faced collectively with the prospect of a retirement (an increasingly larger fraction of our collective lives) being funded out of an asset return stream which in real terms would be around 2%.
There would of course be a remaining equity risk premium, since some companies will always be more successful in their industry than others and you don't know that a priori, so the premium would be a default like component. Perhaps the current equity risk premium could be considered a premium for recessions generally plus a premium for the risk of individual default or failure to compete properly - a competition component. Here I could imagine a default premium and a dividend payment risk premium being in effect the same factor.
How does an equity premium which can be componentised in terms of recent equity factors (size, value, momentum, quality, profit, carry, default) relate to an equity premium for competition and recession? Speaking of factors, it always struck me as weird that announced M&A deals aren't treated as special cases in the calculation of market $\beta$ and CAPM generally. They represent these weird equity moments where the market becomes increasingly certain that the future price of an equity (on deal close date) is known. This is certainly not best modelled as geometric Brownian motion.
Shouldn't we model all stocks as driven by two components - the degree to which they are or could be in play from an M&A point of view, and the degree to which they're best modelled as lognormally distributed stochastic processes. Alternatively, this is just a case of a bifurcated set of market participants - the usual group, plus a new, clearly defined group who, using knowledge of their own and the target's balance sheet, have come up with an alternative valuation for the (target) firm. This is clearly a battle of valuations, since the acquirer is always paying a hefty premium for the target,. What is this premium telling us? Is it telling us that some small part of the market thinks the market generally is wrong in its valuation? Or is it deliberately overpaying the shareholders of the target in order to encourage them to make the deal happen? To what degree is there an M&A premium already in each price? Perhaps the M&A premium is in every stock, to some degree. And it is a premium paid to shareholders somewhat akin to a special dividend, monetised via the share price.
If the M&A premium is a hurdle cost, a transaction cost, and if it is always present to some degree in all stocks, then clearly it can suddenly grow in magnitude at short notice. If so then it is akin to the transaction cost associated with buying a house.
Back to Shiller he believes in bubbles, in surfeits and deficits of confidence, or the tendency for booms and busts. But he believes governments can do something to tamp down the extremity of these cycles. Whereas Friedman believes that government is somewhat complicit in creating them in the first place, thanks to blind tinkering. And the Austrians think that we should honour the regenerative power of booms and busts as a way to keep a pure, thriving capitalism going.
Shiller has an interesting theory of twentieth century economic history. He thinks that the Keynesian model gradually, internally and externally, had the animal spirits surgically removed from the theory. Internally, it built its own models which were themselves increasingly mathematical and had less of a role for confidence, whilst externally, Friedman and to a lesser extent, the Austrians build models which absolutely had no role for animal spirits but which were rational (the the pre-Kahneman sense). This mathematical approach to Keynesianism, Shiller claims, was strategic, since it allowed classical economists to see themselves more in the Keynesian model and hence to 'get on board'. Shiller almost paints Minsky as a John the Baptist figure, decrying this banalisation of Keynesian confidence/uncertainty. Minsky certainly kept that concept close in his own theory. Shiller makes a great point that this emasculated Keynesianism, with no animal spirits, might have brought on board some classical economists, but it opened itself up to criticisms from Friedman et. al. The nadir from the internal critique came in the 70s in the form of the New Classical Economists, who finally expunged animal spirits from the nominal Keynesian approach. Involuntary unemployment was banished from the model. It was replaced by a model where unemployment was a choice, determined by the level of inflation one wanted one's economy to bear.
Important economic events are psychological. Shiller in saying this is not claiming that human psychology itself is cyclic, like circadian rhythms. Rather he is saying that there may be measurable observable phenomena out there in the world, perhaps phenomena engineered by humans themselves to reflect these psychological traits (confidence indices, house price indices, news stories, etc). Indeed I'd say that the act of measuring these also externalises these inner psychological states and hence makes them amenable to scientific experiment. A confidence index is an amazing object in this regard Likewise a consumer price index, a housing index, a cyclically adjusted P/E ratio.
There's a lovely symmetric irony in Shiller's message. Whereas neo-liberals thought that booms and busts were laid at the foot of the governments, central bankers and economists, Shiller thought that the over-sold rational expectations theory was part of a story which lulled economists, governments and us all, with a reassuring but false paradigm of the perfection of the market, so we sleepwalked into the great recession. Shiller is sounding quite Austrian here, but at the story level, rather than at the policy level. The Austrians think we need a flimsier real net underneath us to keep us all competitive. Shiller is saying that the neo-liberal consensus was itself a gargantuan and in effect useless safety net underneath us. The monetarist story played out its psychological effect on us. What would the theoretical Calvinist Minsky have to say? His story was one of the fatalist unavoidability of the business cycle. This was already probably quite appealing in its own way to the neo-liberal school. And here was Shiller painting neo-liberal orthodoxy as itself an element explaining the mad exuberance and eventual collapse.
This divergent approach strikes me a reminiscent of the religious wars of free will and determinism. The determinists felt that god had already chosen those to be saved and hence their actions could not change their ultimate destiny. The counter-reformation position was a lot more tolerant of the power of agency, of the individual, mediated through the church, to make a meaningful difference when faced with the temptations of the devil. By analogy, Shiller is a pope, and the business cycle is he devil; Friedman and the Austrians are Calvinist fatalists, Minsky is a Manichean.
Through all the weakening of the grip which Keynesian 'animal spirits' had exercised over economists and governments, one psychological factor held on - the money illusion as applied to workers wages. The logic was that, through money illusion, workers were unwilling to accept a lower wage, and as a result employers were more often in the habit of sacking workers rather than talking them into settling for a lower wage, when times got tough. This acted as a form of leverage, rather as the spending multiplier did. It amplified preexisting (and perhaps random, according to non-Keynesians) distortions from equilibrium. Added to the volatility of employment.
Another difference in approach which Shiller perceives is his preference for empirical rigour - models have to more strongly agree with reality, and he casts the rational expectations theory as austere, beautiful even, rigorous , but also not well calibrated to observation.
The essence of the Keynesian multiplier effect was in essence the amplificatory power of the feedback loop. So too, claims Shiller, with confidence.
However, the arch empiricist is quite cautious when reporting on economic research which claims to show causal linkages between confidence survey results and subsequent GDP, or between credit spread predictors of GDP. His point here is that these measures could instead be sensitive to a different variable, not confidence, but say expectations on future income. Likewise he sees the correlation between confidence and expected income itself to swing from high to low as the cycle evolves - as the economy enters a downtown this correlation will increase, and at other times, the linkage may be weaker. However he sees the confidence multiplier as a master switch, affecting other more traditional multipliers like the spending multiplier. They can moderate the effectiveness of the spending multiplier. Of course, this is a dangerous point, and an honest one, for an interventionist like him to make. In effect he is claiming that fiscal multipliers are smaller precisely at the time you need them most, when confidence is low and the economy is consequently in the dumps. Perhaps this argues rather for a 'Bazooka' approach to establishing confidence in the markets at the critical stages: central bankers make it powerfully clear that they are determined to grow the economy (that is, to reestablish confidence). In any event, probably monetarists and Austrians alike will appreciate this story of less effective central bank effectiveness just when we need it.
Stories of fairness bolster our confidence in working with the strangers we do work with every day in the economy. Stories of endemic corruption do precisely the opposite. Whilst we can ask consumers and purchasing managers and other economic actors about their self-calibrated feelings of confidence, we don't as yet have any metric materialised to measure the volume of fairness-stories or corruption-stories to which we are all exposed in the daily news. But this ought not to be a difficult problem, though it may require machine learning, especially natural language processing.
But what precisely varies in time here when it comes to community attitudes to corruption or fairness. First of all, notice how fairness builds confidence and corruption tears it down. And it is of course the downside which everyone cares most about. Perhaps our innate confidence builds models of fairness (who knows, perhaps the rational expectations model is the pinnacle of this line of thinking) and base reality reveals to us the ways in which people are not as simple as rational expectations and general concepts of fairness would have us believe. We then lose confidence.
Going back to my first suggestion of a model of the business cycle, as a Poisson process with a time dependent $\lambda$, there may be behind that $\lambda$ a natural growth process which corresponds to an expansive form of confidence growth, and a subtractive model based on the frequency with which scams, corruption, defaults, accounting scandals etc appear. Such models are called non-homogeneous Poisson processes.
Of course, the linking concept here is 'negative news', whether that is in corporate earnings or corruption scandals. If we imagine the set of firms as a pyramid of relations , the firms at the leaf nodes, and sectors at higher levels, then news stories can enter at low or higher levels, and would also have a tendency to spread locally (and upwards), based on the virulence of the news item. Perhaps also the sensitivity of spread is also a function of the general health of that pyramid. A robust pyramid remains exposed only locally whereas a systemically weakened edifice has transmission avenues more widely opened. Modelling the pyramid would be a more adventurous approach. You'd need elements not only for firms but also for government actors, central banks. And you'd need to decide how to handle geographical inter-relationships in this still-globalised economy.
Shiller talks about temporal variation on the perceived penalties and implicit rewards for corrupt behaviour - the idea here is a mini- decline and fall of of the Roman empire, set to the music of Nietzsche's eternal recurrence. He also mentioned that new innovations, including new financial innovations, bring with them a period of lax regulation. Finally, as well as punishment-variability and new technology, Shiller mentions broad cultural changes as having an effect on perceptions of corruption, and gives the example of prohibition era failures to implement the ban on alcohol consumption.
It is entirely possible to imagine a model for confidence, but how to calibrate it? So much would hinge on this calibration. If you made it too sensitive, the model would be unstable. Too robust and it wouldn't predict (or now-cast) recessions well. I think this latter case is so much better than the former. The default setting for all models ought to be a form of ignorance. So, for an equity factor model, it might be a recommendation to invest in the market portfolio without making any differentiation. Models ought to regress in the face of surprises. If you don't know what's coming next, genuinely, then invest and act like you don't know what's coming next. Models ought to contain components which are always looking to degrade their specificity to the point of low information confidence. The models therefore have to continually prove themselves to elevate themselves above their baseline suggestions. So, for example, a model for confidence which didn't currently have strong readings ought to have automatically regressed to a simpler model which doesn't have an informationally rich confidence component.
Shiller tells the interesting story of how one roaring econometric success, the Phillips curve relating the trade off between inflation and employment. Remember how the last remnant of animal spirits which remained in the late '50s and early '60s was the supposed stickiness of nominal labour wages. This was driven by inflation ignorance. Phillips studied how this related to the employment level and found a pretty strong relationship, which Friedman ultimately challenged and destroyed. And the way he destroyed it was to deny money illusion as a causative phenomenon in economics, specifically in labour wage negotiations.
Through what Shiller refers to as a "sleight of hand" Friedman claimed that there is only one non-inflationary/non-deflationary (i.e. inflation-stable) level of employment, not a more or less linear relationship as constructed by Phillips. Friedman suddenly gave the monetary authorities less dials to tweak in the economy. They could no longer decide where to be on the employment/inflation spectrum, but had to, according to Friedman, just hang about at the non-inflationary rate of unemployment.
In theory, you could do what you wanted with inflation, since Friedman thought he'd broken the link with unemployment. As long as you stabilised unemployment. In practice, he recommended a low inflation level, since you wouldn't be punished, as Phillips's model claimed, by high unemployment. Friedman was saying you could have your cake and eat it. Or rather, utility maximisation theory ate the last animal spirit.
On reflection, you could see why man of the people Friedman liked this move. It gave more intellectual credit to the person on the street - he allowed them to be undaunted by the so-called money illusion. They saw through it, making it disappear. Of course, it was (and perhaps still might be) entirely possible that in so doing, this model helped to educate ordinary people to be less susceptible to money illusion, hence bringing it to life in reality. So far (2020), this has not happened.
It just so happened that at this time, inflation and unemployment both increased, something not likely to happen in Phillips's linear model. This evidence was very supportive to the Friedman model. Shiller cites the fact that wage negotiations still don't have cost of living adjustments built in to any serious degree, nor do loan or bond contracts, nor do corporate accounts. We all operate with nominal money as our unit of account.
Shiller makes some very thought provoking and true sounding claims about the psychological importance of stories as mechanisms of remembering - we tend to forget stories we don't retell. And when looking back at historical data, we don't have access to those stories (unless we lived through it ourselves), and hence econometric and quantitative models are using just the price action data they see and are trying to tease out relationships and explain mysteries in an incomplete data-set. This is a deep point. He particularly emphasises new-era stories.
Perhaps the equity risk premium can reverse out atomic default and macro recession risks and you could imply the residual as confidence. Then use this to calibrate the Poisson model. It would be great if this residual confidence measure correlated well with some independent measure of the positivity and negativity of stories found historically.
Shiller sees the 1930s depression as having been made worse by central banks raising rates too much, in various attempts to support the gold standard. He also blames unions for participating in the very money illusion he claims still remains today. But is this something he ought to see as actually blameworthy? Was it ever likely the job of the unions to destroy money illusion? Is he asking the unions to do a job which Friedman later thought he'd do? Surely not. He sees many news stories historically which aren't quantitative in nature and hence are dismissed by modern day economists as anecdotal.
