Column : Animal spirits and trust deficit

Written by MK VENU | M.K. Venu | Updated: Jul 3 2012, 09:19am hrs
After taking charge of the finance ministry, Prime Minister Manmohan Singhs first remarks on the need to revive the animal spirits caught everyones attention. Of course, he used the famous Keynesian term to suggest at a broader level that the reality of Indias economy was better than the perception. There was too much pessimism for a host of reasons which had caused the general sentiment to be somewhat depressed.

The term animal spirits was famously used by Keynes to precisely describe how emotions played as big a role in shaping business cycles as rational thinking by economic agents. Perhaps, in certain phases of the business cycle, emotions played a much bigger role than rational factors. In a book titled, Animal Spirits: How Human Psychology drives the Economy and Why It Matters For Global Capitalism, well-known economists George Akerlof and Robert Shiller have examined in detail how emotions, which often cannot be quantified, play a critical role in economic behaviour. In fact, for much of the 20th century, Keynesian economists have preferred to shy away from delving deeper into these emotional/psychological factors affecting economic behaviour simply because it may not have been fashionable to do so in a discipline so dominated by rational imperatives. As a result, Keynes was reduced largely to quantifiable notions such as expansionary fiscal policy, pump priming and so on.

However, some of the explanations that Shiller/Akerlof offer for a better understanding of the emotional factors which negatively affect business cycles are very relevant to the currently prevailing conditions in Indias political economy. The authors have argued that a deep desire for fairness, and its absence, could cause people to make decisions that arent in their economic best interests. The desire for fairness is an emotional drive and cannot be dealt with in a cold rational manner.

It is quite obvious that Indias aspirational and growing middle class is demanding fairness at various levels, reflecting in the rising tide of civil society protests in recent times. The demand for fairness has permeated various institutions such as the judiciary, sundry regulatory institutions, CAG and so on. Often, some of the pronouncements by these institutions are seen as excessive and irrational by economic analysts. However, there could be some inevitability about the fact that they are acting emotionally rather than rationally, and thus creating conditions for the economy to decline.

In fact, in one chapter, Shiller/Akerlof also talk about how corruption and bad faith create a psychological downer, and how growing awareness of these practices can contribute to a recession. The general mood turns negative as there is loss of faith and trust. It is so obvious that Indian society is going through a crisis of trust today. Businesses dont trust the government and vice versa. Independent judiciary and regulatory institutions dont trust either the government or businesses. Parliament does not trust the judiciary. People are becoming cynical about Parliament. How can the economy revive in these conditions

For instance, fairness and trust are the only basis on which the government can drive public-private partnership projects in the infrastructure space where $1 trillion is planned to be invested over five years. However, many successfully-executed PPP projects are under scrutiny now for allegedly lacking in honesty and fairness. It is a no-brainer that Indias economy can easily come back to 8% growth if it simply creates conditions to build more roads, power plants, ports and railway capacity. There is no need for big bang reforms to achieve this. All we need is a new climate of trust and confidence that various economic agents will act with fairness and in the larger good of society. This may seem like a tautological observation but, when trust and fairness are seen to be lost, it can take a long time and a lot of doing for it to come back. This is partly what reviving animal spirits is all about.

Shiller says when the climate of trust and fairness revives, a lot of strange things start happening which the science of economics may not be able to explain. Workers, for example, will forgo a pay rise even when prices are rising if they know that their firm is facing challenging conditions. This happens only in a climate of trust, which is purely an emotional factor. Rational economics cannot explain this phenomenon. In Japans high growth phase of the 1960s and 1970s, it was said the workers would put in extra hours as a show of protest over some act of the management.

In the Indian context, the Prime Ministers call to revive animal spirits is very welcome. But the key question is how do you bring trust back in the interaction between economic agents. The excessive clamour for auction of resources as a rational way of pricing spectrum, coal and other resources has arisen because there is no more trust left that fair allocation of resources can happen in any other system. It is here that the animal spirits need to be revived.

Therefore, the Prime Ministers call for the revival of the animal spirits has to be seen in a more holistic manner. It cannot be interpreted in the narrow frame of simply creating some rational conditions for an investment revival in the economy. That will simply not work given the trust deficit that exists in the system today.