Animal Spirits — Shiller and Nobel Laureate Make the Case

Contrary to a widespread impression the current situation is not
really a crisis of capitalism. Rather we must recognize that capitalism
must live within certain rules. And our whole view of the economy, with
all of its animal spirits, indicates why the government must set those
rules. It may be true that in the classical economic paradigm there is
full employment. But with animal spirits, waves of optimism and
pessimism cause large-scale changes in aggregate demand. Since wages
are determined partly by considerations of fairness, these changes in
demand do not translate uniformly into shifts in prices and tend to
cause shifts in employment. When demand goes down, unemployment rises.
It is the role of the government to mute those changes.

Moreover, entrepreneurs and companies do not just sell people what
they really want. They also sell people what they think they want, and
not infrequently what they think they want turns out to be snake oil.
Especially in financial markets, this leads to excesses, and to
bankruptcies that cause failures in the economy more generally. All of
these processes are driven by stories. The stories that people tell to
themselves — about themselves, about how others behave, and even about
how the economy as a whole behaves — all influence what they do. These
stories vary over time.

Such a world of animal spirits justifies the economic intervention
of government. Its role is not to harness animal spirits but really to
set them free, to allow them to be maximally creative. A brilliant
player wants a referee, for only when the game has appropriate rules
can he really show his talents. While the sports of baseball and
football haven't changed much in the last century, the economy has —
and American financial regulation hasn't had an overhaul in 70 years.
The challenge for the Obama administration, along with the U.S.
Congress and our SROs, is to invent a new and better American version
of the capitalist game.

WSJ 4-24-09 Good Government and Animal Spirits – Shiller

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