Ever wonder why a seemingly slam-dunk deal suddenly gets thrown off the rails even though none of the terms have changed?

Perhaps you should blame "animal spirits" gone awry, a term economist John Maynard Keynes coined in the middle of the Great Depression to describe the type of "naive optimism" that is a necessary ingredient for businesses to invest, for entrepreneurs to take risks — and for potential homebuyers to sign those documents at the closing table.

Book review
Title: "Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism."
Author: George A. Akerlof and Robert J. Shiller
Publisher: Princeton University Press, 230 pages, $24.95 list ($16.47 on Amazon.com)

Audio interview: Click here to hear an audio interview with co-author Robert J. Shiller.

Ever wonder why a seemingly slam-dunk deal suddenly gets thrown off the rails even though none of the terms have changed?

Perhaps you should blame "animal spirits" gone awry, a term economist John Maynard Keynes coined in the middle of the Great Depression to describe the type of "naive optimism" that is a necessary ingredient for businesses to invest, for entrepreneurs to take risks — and for potential homebuyers to sign those documents at the closing table.

Left to their own devices, however, these same spirits can fall dramatically, thus becoming a psychological barrier to a properly functioning economy.

In their recent book "Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism," economists George A. Akerlof, a Nobel laureate and professor from University of California, Berkeley, and Robert J. Shiller, co-creator of the Standard & Poor’s/Case-Shiller Index for home prices and a professor at Yale University, spent over five years researching, dissecting and explaining the importance of these animal spirits in the global economy.

It is their conclusion that longstanding theories of "rational expectations" and "efficient markets" are so flawed on their own that any credible economic models must take into account these spirits to avoid future catastrophes.

It’s hard to argue with their timing, given the plunge in confidence throughout global credit and capital markets as well as a housing sector which has swung from an unhealthy optimism, disconnected from most underlying fundamentals, to a pessimism that’s proven to be equally damaging.

In the end, the authors suggest that it only is the steady hand of an active government that can hope to contain the damage that animal spirits inflict on otherwise innocent economies, as unfettered free market forces have clearly shown their natural inclination towards juvenile delinquency.

To make this detailed and dense study of modern economic theory available to the average reader, the authors begin with a five-page history primer on the evolution of "Animal Spirits," as well as laying out the foundation for the book’s two major parts.

In the first part of the book, they seek to break down and define how the animal spirits that play into the decisions of investors and consumers can impact economic forces, including the following five basic concepts:

  • Confidence and how its movements can amplify temporary market disturbances.
  • How the setting of wages and prices determine fairness.
  • The temptation by many human beings toward corrupt and antisocial behavior.
  • Money illusion resulting from misunderstandings of how inflation and deflation impact the value of just about everything.
  • The stories that individuals, groups and communities tell themselves to create their own sense of reality in the world.

In the second part of the book, Akerlof and Shiller apply these five animal spirits to subjects ranging from why real estate markets go through cycles and why countries fall into depressions to why people can’t find a job and why saving for the future often seems so arbitrary. …CONTINUED

No doubt, many people remember the extent to which real estate investments became a primary topic at cocktail parties from the late 1990s through 2006, fueled in large part by books whose rationale was simple: If you think a house is a good investment, so will someone else, and homeownership is the best way for the average American to build wealth.

The fact that such books rarely compared the historical inflation-adjusted returns of housing prices (which averaged 0.2 percent per year from 1900-2000) to other investments was a minor inconvenience, as they were instead filled with a variety of success stories that seemed to shout, "See? This could be you, too!"

The "Animal Spirits" authors note that many consumers have shared a strong intuition that home prices — as "they’re not making any more land" — can only go up (an argument that’s been used to defend real estate booms for more than a century).

Emboldened by books such as "Are You Missing the Real Estate Boom?" by former National Association of Realtors economist David Lereah in 2005, it’s easy to see why the so-called animal spirits could motivate all but the most conservative investors.

At the same time, a huge push by the U.S. Department of Housing and Urban Development at the beginning of the decade to boost homeownership led to the lowering of credit standards by Fannie Mae and Freddie Mac, which in turn gave subprime lenders the justification to promote their loan products with little regard to normal underwriting standards.

In the end, Akerlof and Shiller argue that it was a combination of cultural and psychological forces — given credibility by institutional backing — that allowed these animal spirits to lead the housing market’s unsustainable boom.

So what do the authors say we can do to prevent these spirits from rising up again and assuming control of the housing or financial markets? For starters, they think we’re on the precipice of another major shift in the stories people tell about how the economy works, with some previous ones including the election of Ronald Reagan, the end of the Great Depression, and the period following the Civil War Reconstruction.

In this next shift, Akerlof and Shiller envision a move away from the "invisible hand" theory of largely unregulated markets to an economy in which government will play a stronger role.

Since the primary challenge of this will be to avoid stomping out the type of innovation and risk-taking that gives capitalism its strength, both individuals and government will have to assume more responsibility in learning how the economy works when making decisions on saving money, making investments in the stock market or in housing, and the role of pension programs such as Social Security.

For the savvy real estate agent or broker, this shift in awareness of economic pitfalls could also provide a rare opportunity — that of becoming a trusted adviser in addition to assembling listing data, showing homes, and shepherding clients through the sales process.

Because as the Internet and other technologies continue to eat away at the protected tools agents have used for decades, success will come to those who understand economics and human psychology as much as the best comps, school scores and crime statistics.

Click here to listen to Patrick Duffy’s interview with co-author Robert Shiller.

Patrick S. Duffy is a freelance writer, a principal with development consultants MetroIntelligence Real Estate Advisors and author of The Housing Chronicles Blog.

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