If you wish to sample conventional economic wisdom in its refined form, you could do worse than to consult the McKinsey Quarterly, a recent issue of which contains a curious meditation on the subject of “Animal Spirits” by Yale’s Robert Shiller and Berkeley’s George Akerlof, professors of economics who together have written a book by that title.
“Animal spirits” is John Maynard Keynes’s abstraction of all that goes into quotidian economic decision-making beyond the rigorously rational pursuit of self-interest. He wrote, in Chapter 12 of his General Theory, “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere.” Conservatives are wrong to deny themselves the clarity of Professor Keynes’s insights, and the pleasures of his lucid prose, only because they object to the policies he advocated and to those that are advocated in his name.
Animal spirits are indeed at play, and mischievously so, both in the marketplace and among those who seek to govern the marketplace. It is characteristic of our academic caste that Professors Shiller and Akerlof attend to the former case but are blind to the latter, and so they have produced an essay that is not so much conventional as convention itself, arguing, in a series of bland metaphors, that economic exorcists in Washington must be deployed against animal spirits in the marketplace: “If we thought that human beings were totally rational and acted mainly from economic motives, we, like Adam Smith and his followers today, would believe that governments should play little role in regulating financial markets. . . . But on the contrary, we believe that animal spirits play a significant and largely destabilizing role. Without government intervention, employment levels will at times swing massively, financial markets will fall into chaos, scoundrels will flourish, and huge numbers of people will live in misery.”
There is no need to address the problems of that passage beyond cataloguing them: We have lots of government intervention in the economy, but employment levels do swing, financial markets have fallen into chaos, scoundrels do flourish with great exuberance, etc. And neither Adam Smith nor his intellectual heirs believe that economic man is an icy rationalist, or even that he is rational, broadly defined. Ludwig von Mises put the idea into theoretical form, but it has long been understood that man acts rationally in the sense that he takes actions that seem to him sensible in order to achieve a certain end, but that end itself may be irrational, erroneous, or criminal: Scientific researchers act rationally to achieve certain ends; so do serial killers, religious fanatics, drug addicts, and Wall Street traders.
The fallacy implicit in the conventional argument for more robust financial regulation is that animal spirits — the whole menagerie of greed, panic, pride, thrill-seeking, irrational exuberance — distort only profit-seeking activity. But they are at least as likely to distort efforts to regulate profit-seeking activity. In truth, the animal spirits of regulators probably are more dangerous than those of Wall Street sharks: Competition and the possibility of economic loss constrain players in the marketplace, but actors in the political realm have the power to compel conformity and uniformity among those under their jurisdiction. The entire economy is yoked to their animal spirits, and the housing bubble was a consequence of that fact. We have bred an especially dangerous hybrid creature in the “too big to fail” private corporation, the bastard offspring of a union between Wall Street’s animal spirits and Washington’s.
That may all sound a bit airy-fairy, but it matters. The animal spirits of politics are at this moment informing Washington’s efforts to respond to the financial crisis with much more energy and consequence than are insights gleaned from good economics. That is why we have heard a lot of loose talk about bankers’ pay but very little discussion of the Recourse Rule.
What in hell is a Recourse Rule? It’s not exactly Topic A, and that is the point. But there has been endless talk about bankers’ paychecks. There also has been scholarly and professional attention paid to the question. One recent National Bureau of Economic Research paper was published under the refreshingly straightforward title, “Bank CEO Incentives and the Credit Crisis.” This is not a philosophical treatise, but a work of largely empirical economic research, and it concludes: “There is no evidence that banks with CEOs whose incentives were better aligned with the interests of their shareholders performed better during the crisis and some evidence that these banks actually performed worse both in terms of stock returns and in terms of accounting return on equity. Further, option compensation did not have an adverse impact on bank performance during the crisis. Bank CEOs did not reduce their holdings of shares in anticipation of the crisis or during the crisis; further, there is no evidence that they hedged their equity exposure. Consequently, they suffered extremely large wealth losses as a result of the crisis.” This is not the final word on the subject (there will be no final word on the subject), but it would dampen the cries of “Greed!” and “Excess!” that characterize our current political discourse, if our political class were rational. But it is in thrall to animal spirits, and animal spirits demand a quarry. Megan McArdle of The Atlantic calls this the “evil-man theory of failure.” Something went wrong, and somebody must be blamed.
We know a lot about compensation in the banking industry. For a few dreary months, Americans were talking almost as much about bankers’ pay as they were about baseball players’ pay, speaking sagely over their beers. On the other hand, if you are having a beer and the guy next to you starts talking about the Recourse Rule, you are either in downtown Manhattan or in Washington, D.C., and you are in deeply nerdy company.
The Recourse Rule, which is part of the international body of banking regulations called Basel I, has to do with how banks are required to mitigate the risks of certain kinds of investments they hold. Safe investments, such as U.S. Treasury bonds, require no offsetting capital, which, in the jargon, is described as a zero risk weight. A very risky investment might have a risk weight of 100 percent. As Jeffrey Friedman of the University of Texas explains, under the current rules an individual mortgage has a risk weight of 50 percent, but AAA-rated securities have a risk weight of only 20 percent. That means that banks can package their mortgages into securities and buy them back in the form of a mortgage-backed bond, with a much more attractive risk weighting. That frees up capital for the banks to lend out for interest, meaning more profit. It’s a classic case — one that should be a textbook case, in fact — of regulations creating perverse incentives. It’s probably a big part of the reason that banks became so heavily invested in mortgage-backed securities and underestimated the risk involved with those assets.
There will be free-market ideologues who will latch onto the story of the Recourse Rule and declare that regulation is the real cause of the crisis. Of course it is not. But there is good reason to believe that issues raised by the Recourse Rule and other related regulations go a long way toward helping us understand how and why bad decisions were made. And if we take seriously current economic scholarship, there is good reason to believe that these somewhat dry and technical issues will tell us much more about the crisis than will the scope and shape of bankers’ compensation. But which of those is Barney Frank more likely to work himself into a C-SPAN lather about? On the day this article was composed, there were 525 live articles on Google News referring to “corporate greed.” There were three referring to the Recourse Rule: Mr. Friedman’s column in the Wall Street Journal, an Atlantic blog post referencing Mr. Friedman’s column, and an article in French.
Professors Shiller and Akerlof would have us loose the animal spirits of politicians in order to tame the animal spirits of investors, like medieval physicians treating poison with poison. Their invocation of “animal spirits” is in fact apropos, inasmuch as our democratic beliefs about the workings of the economy are, at heart, superstitious. Anybody reading Sir James George Frazer’s The Golden Bough, with its account of priest-kings being ritually murdered when the crops fail, has a model for understanding American presidential politics vis-à-vis the economy. Professors Shiller and Akerlof are offering the equivalent of a witch doctor’s dance to tame the animal spirits, and their calls for regulation have the quality of an incantation. But the regulatory enterprise is always and everywhere constrained by the fact that future conditions are contingent upon present actions, an insight at least as old as Aristotle. There will be innovation in finance, and one of the things that financiers will innovate in reaction to is regulation.
Which isn’t to say that the regulatory enterprise is inherently hopeless: There are better and worse regulations, and there are more intelligent and less intelligent applications of them. But our legislators and regulators are much more likely to be swayed by their resentment of Wall Street paychecks than by well-reasoned analysis of our present regulatory defects, and we will solve “problems” such as CEO pay that are not, probably, problems. But Professors Shiller and Akerlof, janissaries of Convention, simply argue for more regulation for the sake of regulation. And the word “regulation” unwed to a regulatory proposal is without intellectual content — Shiller and Akerlof might as well be calling for a rebalancing of our melancholic and sanguinary humors. They are shaking the magic spear.
– Kevin Williamson is a deputy managing editor of National Review.