Behaviourial finance

TO UNDERSTAND HOW economies work and how we can manage them and prosper, we must pay attention to the thought patterns that animate people’s ideas and feelings, their animal spirits. We will never really understand important economic events unless we confront the fact that their causes are largely mental in nature.
It is unfortunate that most economists and business writers apparently do not seem to appreciate this and thus often fall back on the most tortured and artificial interpretations of economic events. They assume that variations in individual feelings, impressions, and passions do not matter in the aggregate and that economic events are driven by inscrutable technical factors or erratic government action. In fact, as we shall discover, the origins of these events are quite familiar and are found in our own everyday thinking 
In the intervening years the world economy has moved in directions that can be understood only in terms of animal spirits. It has taken a rollercoaster ride. First there was the ascent. And then, about few years ago, the fall began. But oddly, unlike a trip at a normal amusement park, it was not until the economy began to fall that the passengers realized that they had embarked on a wild ride. And, abetted by this obliviousness, the management of this amusement park paid no heed to setting limits on how high the passengers should go. Nor did it provide for safety equipment to limit the speed, or the extent, of the subsequent fall.

Traditional economics teaches the benefits of free markets. This belief has taken hold not just in the bastions of capitalism, such as the United States and Great Britain, but throughout the world, even in countries with more established socialist traditions, such as China, India, and Russia. According to traditional economics, free market capitalism will be essentially perfect and stable. There is little, if any, need for government interference. On the contrary, the only risk of major depression today, or in the future, comes from government intervention.
This line of reasoning goes back to Adam Smith. The basis for the idea that the economy is essentially stable lies in a thought experiment which asks: What do free, perfect markets imply? The answer: If people rationally pursue their own economic interests in such markets, they will exhaust all mutually beneficial opportunities to produce goods and exchange with one another. Such exhaustion of opportunities for mutually beneficial trade results in full employment. Workers who are reasonable in their wage demands—those who will accept a wage that is less than what they add to production—will be employed. Why? If such a worker were unemployed, a mutually beneficial trade could be arranged. An employer could hire this worker at the wage she requires and still have some spare extra output for a larger profit. Of course some workers will be unemployed. But they will be unable to find work only because they are engaged in a temporary search for a job or because they insist on pay that is unreasonably high greater than what they add to production. Such unemployment is voluntary.

There is a sense in which this theory about the economy’s stability is remarkably successful. For example, it explains why most people who seek work are employed most of the time—even in the troughs of severe depressions. It may not explain, for example, why 25% of the U.S. labor force was unemployed in 1933 at the height of the Great Depression, but it does explain why, even then, 75% of the workers who sought jobs were employed. They were engaging in the mutually beneficial production and trade predicted by Adam Smith.

So, even at its worst, this theory deserves high marks—at least by the criterion of a schoolboy we once overheard at a restaurant. He was complaining about the C he had received on a spelling test—despite the fact that 70% of his answers were correct. Furthermore the theory does so well even in its worst prediction in two hundred years. Most of the time—as now, when the U.S. unemployment rate is still 6.7% (although rising)—it predicts remarkably accurately.

Consider yet again the Great Depression. Few people ask why employment was as high as 75% in 1933. Instead the common question is why 25% of the labor force wasunemployed. To our mind macroeconomics concerns departures from full employment. Failure to be at such full employment must then result from a departure from the classical model of Adam Smith.We do believe, like most of our colleagues, that Adam Smith was basically right regarding why so many people are employed. We are also willing to believe, with some qualifications, that he was essentially correct about the economic advantages of capitalism. But we think that his theory fails to describe why there is so much variation in the economy. It does not explain why the economy takes rollercoaster rides. And the takeaway message from Adam Smith—that there is little, or no, need for government intervention—is also unwarranted.

In contrast, John Maynard Keynes sought to explain departures from full employment, and he emphasized the importance of animal spirits. He stressed their fundamental role in businessmen’s calculations. “Our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing,” he wrote. If people are so uncertain, how are decisions made? They “can only be taken as a result of animal spirits.” They are the result of “a spontaneous urge to action.” They are not, as rational economic theory would dictate, “the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

In the original use of the term, in its ancient and medieval Latin form spiritus animalis, the word animalmeans “of the mind” or “animating.” It refers to a basic mental energy and life force. But in modern economicsanimal spirits has acquired a somewhat different meaning; it is now an economic term, referring to a restless and inconsistent element in the economy. It refers to our peculiar relationship with ambiguity or uncertainty. Sometimes we are paralyzed by it. Yet at other times it refreshes and energizes us, overcoming our fears and indecisions.

five different aspects of animal spirits and how they affect economic decisions—confidence, fairness, corruption and antisocial behavior, money illusion, and stories:

• The cornerstone of our theory is confidenceand the feedback mechanisms between it and the economy that amplify disturbances.
•  The setting of wages and prices depends largely on concerns about fairness.
• We acknowledge the temptation towardcorrupt and antisocial behavior and their role in the economy.
• Money illusion is another cornerstone of our theory. The public is confused by inflation or deflation and does not reason through its effects.
• Finally, our sense of reality, of who we are and what we are doing, is intertwined with the story of our lives and of the lives of  others. The aggregate of such stories is a national or international story, which itself plays an important role in the economy.