Austan Goolsbee

Theories of the Financial Crisis: Animal Spirits

[digg-reddit-me]David Brooks is a reliable barometer of the opinions and beliefs of the Washington establishment (and I don’t mean that as an insult.) The figure he cuts is a rather odd combination of an amateur (but insightful) anthropologist and a insider protecting the system. All of this makes it significant to note that David Brooks has on several occasions stated that the root of this financial crisis is a “loss of confidence.” He has stated this in several of his columns, including his one immediately following the September 15 freefall:

At its base, the turmoil wracking the world financial markets is a crisis of confidence.

Many of Geithner’s critics have said that he is treating the financial crisis primarily as a liquidity crisis – which is defined as “a ‘general feeling of mistrust in the banking system’ conducting to a temporary disappearance of credit.” This is a common form that a crisis of confidence in the financial system takes.

The Congressional Oversight Panel in their report [pdf] written to evaluate the TARP bailouts, for example, described what they saw as one of Geithner’s asusmptions :

One key assumption that underlies Treasury’s approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from nonfunctioning markets for troubled assets. The debate turns on whether current prices, particularly for mortgage-related assets, reflect fundamental values or whether prices are artificially depressed by a liquidity discount due to frozen markets – or some combination of the two.

Paul Krugman has also often made this point – stating that Geithner seems to be acting as if we were in a liquidity crisis – in which the loss of confidence is the cause of the problem – instead of a solvency crisis – in which the loss of confidence is a symptom of the problem.

Geithner, for his part, rejects this assertion that he is treating the problem as a liquidity crisis. When asked, he said it was, as all financial crises are, a combination of the two.

If this is primarily a crisis of confidence, there have been a number of historic examples of how these were contained. For example, this is a description of the resolution of the Panic of 1907 – in which J. P. Morgan’s timely intervention demonstrated how this could be done:

Shipments of gold were on the way from London to New York, and confidence had returned to the French Bourse, “owing,” reported one paper, “to the belief that the strong men in American finance would succeed in their efforts to check the spirit of the panic.” During a panic, confidence is almost as good as gold.

As politicans saw how these crises could be contained – and as they realized Morgan who had successfully beaten back several of these panics was getting near his end – they created the Federal Reserve to officially take on the role Morgan had been unofficially occupying, the lender of last resort and de facto regulator.

As panics are short, they generally do not affect the fundamentals of the economy – but in a liquidity crisis such as this, restoring confidence is a more delicate task. It involves restoring what John Maynard Keynes referred to as “animal spirits” – those positive energies that cause people to be trusting and optimistic that are essential to a thriving economy. As Keynes wrote in his seminal work, The General Theory of Employment, Interest, and Money:

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. 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 the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. [my emphasis]

This idea of animal spirits has created an opening for what appears to be Obama’s favorite branch of economics – behavioral economics. While economics generally treats human beings as homo economics, rational, self-interested (indeed, selfish), individuals who act entirely to serve their best interest (and who know what their best interest is) – behavioral economics takes a more scientific view of human beings. They try to understand human behavior through testing and real-life examples rather than through theoretical models. Some of Obama’s top advsiors from Cass Sunstein to Austan Goolsbee are known to be proponents of behavioral economics. And a recent article by Chrystia Freeland in the Financial Times, suggests that Obama’s administration may be using behavioral economics to solve this crisis, describing how “emotions might yet save the economy“:

Judging by the upbeat economic message we have been hearing from the White House, the Treasury and even the Federal Reserve over the past six weeks, that is a shrewd guess. The authors argue that “we will never really understand important economic events unless we confront the fact that their causes are largely mental in nature”. Our “ideas and feelings” about the economy are not purely a rational reaction to data and experience; they themselves are an important driver of economic growth – and decline.

I don’t have the expertise to judge if this crisis is one of solvency or confidence or whatever else it may be. But at this point there is a feeling – almost of a wind at the back of the economy. (I certainly hope this is the case.) It does seem to me that the lack of confidence is a major cause (rather than merely a symptom) of this crisis; and Obama’s gradualist approach, with every move telegraphed and thus predictable – seems to be generating confidence.

I’ve heard from a few people that there is a growing concern that Obama is anti-free-trade.

This concern has a basis in Obama’s record – mainly from his rhetoric in Ohio during the primary fight with Hillary Clinton and to some extent the fact that he is a Democrat and needed the support of the labor unions. But to a large degree the exaggerated fears of many businessmen comes from comments made by the Republicans during the campaign – as John McCain’s campaign was first (ridiculously) calling Obama “the most protectionist candidate that the Democratic Party has ever fielded” before his campaign went on to call Obama a supporter of comprehensive sex education for kindergartner, a Marxist, a socialist, and a friend to terrorists.

This has led to a series of conflicting impressions of Obama and his position on trade – from statements during the Ohio campaign that “we can’t keep passing unfair trade deals like NAFTA that put special interests over workers’ interests” to his later point – when asked about his rhetoric about NAFTA during the Ohio campaign that, “Sometimes during campaigns the rhetoric gets overheated and amplified.” Indeed – despite the appeal of populist protectionist rhetoric (some 60% of Americans think free trade and NAFTA have been bad for people like them), Obama chose to attack protectionism in the general campaign: “[n]ot only is it impossible to turn back the tide of globalization, but efforts to do so can make us worse off.” At least in part, Obama’s friendlier stance towards free trade has to be understood as a tactical move on his part as he was certain to be to the left of McCain on this issue. McCain has never even made an issue out of any labor or environmental protections relating to the issue and would have had serious problems with economic conservatives if he moved to the left on this issue as they never trusted him to begin with.

Even aside from the change in rhetoric, there is considerable evidence that has led numerous reasonable observers to believe Obama is, in fact, in favor of trade even as he is concerned with some of free trade’s side effects on American workers and the economy. Obama, for one, described himself as a “pro-growth, free-market guy.” Even the arch-conservative Weekly Standard was forced to concede in the midst of the general election campaign that Obama’s two main economic advisors Jason Furman and Austan Goolsbee, while liberals, were “centrist, pro-free traders.” George F. Will, my favorite columnist and a paleo-conservative – described Goolsbee as the best sort of liberal economist his conservative leanings could imagine:

Goolsbee no doubt has lots of dubious ideas – he is, after all, a Democrat – about how government can creatively fiddle with the market’s allocation of wealth and opportunity. But he seems to be the sort of person – amiable, empirical and reasonable – you would want at the elbow of a Democratic president, if such there must be.

Naomi Klein attacked these two herself as ideologically impure in a piece in The Nation magazine – and while I find Klein to be provactive, I think a pro-free trader could hardly have a better endorsement than an attack by Klein.

Obama’s official position on trade has remained consistent – even as his focus has changed over the course of the campaign. What has struck me about all of Obama’s positions is the extent to which they begin with an appreciation of conservative ideas – as his health care plan works within the market rather than by goverment fiat; as his stance on affirmative action reflects traditional concerns about whether we are trying to ensure the equality of oppurtunity or equality of the ends. His views on trade seem similar – as he embraces free markets and free trade – but wants to mitigate the negative side effects.

The Council on Foreign Relations, a group with a considerable interest in free trade, vouched for Obama’s support:

Sen. Obama (D-IL) generally supports free trade policies, though he has expressed concern about free trade agreements that do not include labor and environmental protections.

Tim Hanson and Nate Weisshaar of the Motley Fool probably best described the most reasonable concerns about Obama’s record on trade in their piece asking “Will Obama End Global Trade?” (the answer was, “Nope.”):

While Obama’s campaign literature will tell you that his goals are fairer trade, more assistance for displaced American workers, and greater global environmental protections, there is some global worry that an Obama administration might impose and sustain protectionist policies in order to reward labor union support for his campaign and get our economy back on its feet.

As private sector labor unions have been decimated in the global economy, and as Obama and the liberal consensus views them as part of the solution rather than a major problem, it’s hard to see exactly what steps Obama can take to rejuvenate unions.

In the end, the best way to understand and predict Obama’s trade policies is as part of his view of economics in general. Obama’s economic positions are consistent with a broad Democratic consensus that has emerged in the past decade – bringing together the two warring sides of the Clintonian era, short-handed as Robert Rubin versus Robert Reich for Clinton’s Labor and Treasury Secretaries. The Rubin school believed in expanding free trade, reducing deficits, encouraging overall growth without regard to it’s distribution, and deregulation. The Reich school believed in protecting labor unions, mitigating the effects of globalization through an expanded safety net and job-retraining programs, environmentalism, and was concerned with inequality. Over the past decade, many figures on both sides of this ideological divide have found worth in the ideas of their one-time competitors – as David Leonhardt’s New York Times Magazine piece called “Obamanomics” explained.

This Democratic consensus views free trade as a positive force in the world – but one that has numerous side effects that are negative. The role of government in this picture is to try to mitigate the negative effects of free trade – especially those temporary effects of the transition to a more globalized economy. Most of Obama’s domestic agenda is designed to accomplish these purposes – from the investment in a green energy industry to investment in infrastructure to health care reform to financial reforms. His nuanced position on trade reflects this same desire – to mitigate the destabilizing effects of globalization while acknowledging it’s benefits.