Author: Robert Shiller

Source: Folha de S. Paulo, 15/03/2009

SPECIAL FOR “FINANCIAL TIMES”

LYDIA LOPOKOVA, wife of economist John Maynard Keynes, was a famous ballerina.
He was also a Russian emigrant.

For this reason, Keynes knew from the experience of his in-laws the horrors of life in the worst of socialist economies. But he also knew firsthand the great difficulties that life under uncontrolled and unregulated capitalism can offer. He lived through the British depression of the 20s and 30s and this inspired him to find an intermediate path to modern economies.

We are witnessing, in this financial crisis, a revival of the Keynesian economy. We went back to discussing “The General Theory of Employment, Interest and Money”, written in 1936, written during the Great Depression.

That era, like the current one, saw many calls for the end of capitalism as we know it. The 30s were defined as the height of communism in the West. Keynes' intermediary was intended to avoid unemployment, panics and capitalism's mania. It would also avoid the political and economic controls of communism. The book became the most important work of economics of the 20th century due to its sensible and balanced message.

In times of high unemployment, governments with a good credit history should expand demand through public spending supported by budget deficits. Then, in times of low unemployment, governments should pay off debts incurred. With this seemingly minimal change in procedure, a capitalist system could be stable. There would be no need for radical surgery on capitalism.
The adherents of Keynes's message were so eager to get this simple policy implemented that they failed to realize, or perhaps deliberately disregarded, that the general theory had a deeper and more fundamental message about the way in which capitalism works, though only mentioned briefly. The book explained why capitalist economies, if left unchecked, were essentially unstable. And it explained why governments needed to play a counterweight role in order for capitalist economies to function well.

The key to this perception was the role that Keynes attributed to people's psychological motivations, which were generally ignored by macroeconomists. He called them “animal spirits” and believed they were especially important in determining people's willingness to take risks. Businessmen's calculations, he said, were precarious. “Our knowledge base for determining the performance, ten years from now, of a railroad, a copper mine, a textile factory, the intangible value of a patented medicine, a transatlantic, a building in the City of London, is very small and occasionally non-existent. ” Despite this, people somehow make decisions and act. This "can only be understood as a result of the animal spirit". There is a “spontaneous urge to act”.
There are times when people are spontaneously adventurous. The adventures are sustained, at these times, by a joyful faith in the future and by confidence in economic institutions. This represents the upward curve in the business cycle. But the animal spirit can also move in the opposite direction, when people are too cautious.

Today, it is possible to treat the psychological basis of the animal spirit much more clearly.
For example, social psychologists have demonstrated the extent to which stories and narratives, especially those of human interest, motivate people's behavior. These stories can be of far greater value than abstract calculations. People's economic moods are largely based on the stories they tell themselves and each other about the subject.
We have seen stories like these appearing and disappearing in rapid succession in recent years. First we had the internet bubble and the stories about young millionaires that made everyone jealous. It broke out in 2000, but was soon replaced by a new one, this time involving people who profited by buying and reselling real estate smartly.

This craze was the product of not just a story about people but a story about how the economy worked. It was part of a story in which all investments in securitized mortgages were safe, as so many smart people were involved. All those enviable people were acquiring that kind of asset and they were certainly checking it out, so we wouldn't have to do it. It was enough to accompany them.
What has allowed this craze and these stories to persist for so long? To a large extent, we entered the current crisis due to an incorrect economic theory, a theory that itself denied the role of the animal spirit in getting us involved in panics and manias.

According to the standard “classic” theory, which goes back to Adam Smith and the “Wealth of Nations” of 1776, the economy is essentially stable. If people rationally pursue their economic interests, in free markets, they will exhaust all mutually beneficial opportunities to produce goods and trade with each other. Such exhaustion of mutually beneficial trade opportunities would result in full employment. Under this theory, the result could not be different.
Of course, there will be some unemployed. But they will be unable to find employment just because they are temporarily looking for work, or because they insist on being paid unreasonably high wages. Unemployment like this is seen as voluntary, in terms of theory, and therefore not worthy of sympathy.
Classical theory also tells us that financial markets will be stable. People will only carry out transactions that they consider beneficial to them. When entering markets, they will do their homework to ensure that what they are buying is worth the amount they are paying.

What this theory neglects is that there are times when people trust too much. Nor does it take into account that, if it can do so profitably, capitalism will not only produce what people really want, but what they think they want. The system can produce the drugs that people need. This is something that people really want. But if you can do it profitably, it will also produce what people mistakenly think they want.

Capitalism will produce false potions. Not only that, it can also produce the desire for them. This is a negative aspect of it. Standard economic theory did not take into account that asset buyers and sellers might not exercise their responsibility and that the market would not be selling them insurance against the risk of the complex securities they have purchased, but the financial equivalent of a false potion.

There is a broader moral to all of this regarding the nature of capitalism. On the one hand, we want to take advantage of Adam Smith's wisdom. For the most part, the products that capitalism manufactures are what we really want, at a price that we are willing and able to pay. On the other hand, when confidence is high, and because financial assets are difficult to value for those who buy them, people are willing to purchase fake potions, and they do. And when that is discovered, as it invariably should, trust disappears and the economy is bitter.

It is the government's role to ensure, on two levels, that events like these do not occur. First, it has a duty to regulate asset markets in order to prevent people from being falsely attracted to acquire illusory assets. Standards like these for financial products make as much sense as taxes on the food or medicine we consume. But we don't want to eliminate the good parts of capitalism when we exclude the bad parts. To take advantage of the good parts, when fluctuations occur, it is the government's role to ensure that those who want and can produce what others want to buy are able to do so. It is the government's role, therefore, to maintain full employment through its compensatory fiscal and monetary policies.
The principles that underpin this type of economy are not the same as those in force in the socialist model. The government, as far as possible, is only creating the macroeconomic conditions that will allow the economy to function well.
This is the role of the government.
Your role is to guarantee a wise laisser-faire. This is not a completely open capitalism recommended by current theory and which seems to have been accepted as a gospel by economic planners and also by many economists since the Thatcher and Reagan governments. The capitalism we propose is a significant compromise between those who see economic disasters and the unemployment of uncontrolled capitalism, on the one hand, and those who believe that the government should not play any role, on the other.

The idea that uncontrolled and unregulated capitalism would invariably produce positive outcomes was an incorrect economic theory as to the way in which capitalist societies behave and as to what causes their crises.
This incorrect economic theory does not take into account the way in which the animal spirit affects economic behavior, nor the role of confidence-building narratives and false potions in economic fluctuations.

ROBERT SHILLER holds the Arthur M. Okum Chair in Economics at Yale University and co-founder and chief economist at MacroMarkets.

This article was originally published in the “Financial Times”

Translation of PAULO MIGLIACCI