A White House Seized By The Animal Spirits

Posted by Michael Scherer Friday, March 13, 2009 at 12:53 pm

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White House Budget Director Peter Orszag is a numbers guy, a propeller head as President Obama would say. But as David Von Drehle and I write in this week's print version of TIME, Orszag has been spending his time recently reading not about spreadsheets, but about psychology. In particular, he has been reading a new book by the economists George Akerlof and Robert Shiller called "Animal Spirits: How Human Psychology Drives The Economy, and Why It Matters For Global Capitalism."

The book's thesis is that modern economics has undervalued the role of the spirits--psychological phenomena like confidence, story telling, fairness and corruption--in shaping economic patterns. The root word of credit, they point out, is the Latin "credo," meaning "I believe." A credit crisis, therefore, can be understood as a crisis of belief. They write:

Economists have only partly captured what is meant by trust and belief. Their view suggests that confidence is rational: people use the information at hand to make rational predictions. Certainly people often do make decisions, confidently, in this way. But there is more to the notion of confidence. The very meaning of trust is that we go beyond the rational. Indeed the truly trusting person often discards or discounts certain information. She may not even process the information that is available to her rationally; even if she has processed it rationally, she till may not act on it rationally. She acts according to what she trusts to be true.

That is a near perfect description of what led to the current crisis. The bank barons, Federal Reserve chairmen, Congressional regulators, stock investors, home buyers, investment bankers, derivatives traders, the financial press and the general public all had an irrational confidence in the economy. From the captains of industry down to the neighbor next door, we spent more than we had because we believed. We discarded or discounted information that challenged this believe, most notably the ridiculously unprecedented spike in real home values.

Now, as several White House officials constantly point out, we are suffering from the flip side of a confidence bubble. The financial crisis, which can be measured in bank stress tests, stock market drops and the Libor index, threatens to become, in the view of Obama's team, a confidence crisis. The fate of the bank bailout, the housing plan and the G20 meeting next month will not determine our future alone. We are all at the mercy of the Animal Spirits. This is how Larry Summers, Obama's top economic adviser, described the situation today at Brookings:

In the past few years, we've seen too much greed and too little fear; too much spending and not enough saving; too much borrowing and not enough worrying. Today, however, our problem is exactly the opposite. It is this transition from an excess of greed to an excess of fear that President Roosevelt had in mind when he famously observed that the only thing we had to fear was fear itself. It is this transition that has happened in the United States today.

In other words, because we had too much confidence, we now need even more. Later in the speech, Summers prepared remarks called for him to refer to the need to "restore sustained economic growth." Tellingly, he said instead, "restoring confidence in sustained economic growth." The two concepts have become one. We are in a race against our own minds. (More after the jump.)

On Thursday afternoon, President Obama expanded on this same concept in a meeting with captains of industry at the Business Roundtable. He made the incisive point that the modern news cycle can have the effect of exacerbating the Animal Spirits, the very same cycle that could have lead a viewer of CNBC two years ago to suspect the bull market would never end.

We live in such a rapid-fire information-rich environment that people's attention spans go like this. And that makes for volatility in confidence. A smidgen of good news, and suddenly everything is doing great. A little bit of bad news -- oh, we're down in the dumps. And I am obviously an object of this constantly varying assessment. (Laughter.) I'm the Object-in-Chief of this varying assessment. (Laughter.) So my view -- you know, people ask me sometimes, well, you seem like a pretty calm guy, how do you do that? I say, well, look, I don't think things are ever as good as they say and they're never as bad as they say. And things two years ago were not as good as we thought because there were a lot of underlying weaknesses in the economy, and they're not as bad as we think they are now.

This has been the message of the White House, more or less, ever since Obama announced in the Oval Office that prices might make stocks a pretty good buy right now. The White House is trying to recreate a sense of confidence by pointing out all the measurements that suggest the sudden loss of confidence may be causing the same irrational result that the confidence bubble created. Of course, the White House must walk a delicate line here, for even the smartest people in the Washington do not know when the markets will stop sinking. No one can predict the animal spirits. As Obama said Thursday, "The market is going to be responding to all this information out there and, you know, the whole issue of animal spirits in the marketplace and when suddenly a rally catches, you know, you guys know that better than I do. But my focus has to be on the long term. And my long-term projections are highly optimistic -- if we take care of some of these long-term structural problems."

In the meantime, we all hold on, both to the railings and our own state of mind. The greatest fear in Washington's corridors of power now is that we collectively lose our minds again, becoming irrationally pessimistic just as we were all irrationally optimistic a few years ago. The policy responses--the bank bailout, the housing plan, the regulations--are after all, as Summers would say, as much about restoring confidence in sustained economic growth as they are about restoring economic growth. We are, it turns out, slaves to the Animal Spirits. They have brought us to our knees. And now they are the only things that can save us.