Wednesday, October 19, 2011

The Animal Spirits of Capitalism

The story of the economy today is a story about confidence. Investors and consumers alike are uncertain about the future and thus they tend to hold on to their money and spend less on big durable goods and investments. The fact that this crisis was precipitated by an over investment in housing making restoring confidence doubly hard.

John Maynard Keynes famously said, "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.[3]

Wall Street is the tale of the bulls and the bears. And the problem is they tend to run in herds. When things look good, investors run with the bulls and when things look bad, they run away with the bears. Rational thought has some bearing on this trend but not so much on either end of the spectrum. When things are going particularly well, irrational exuberance sets in leading to a chain of overinvestment in the latest thing, corruption and ultimately a crash of confidence.

This is all very well and good but what do we do about it? How do we restore confidence, that is the question.

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