The "Animal Spirits" Fudge Factor

Marcus Nunes directed me to an interesting quotation from Bill Gates:

Too bad economists don’t actually understand macroeconomics,” . . . It’s not like physics where you take certain inputs and you predict certain outputs. Will interest rates ever return to normal, and why aren’t they returning to normal? You won’t get a consensus between economists quite the way that if you dropped a ball out your window and called up physicists and asked, ‘What the hell happened?’ There’s so many factors including what [economist John Maynard] Keynes called ‘animal spirits’ in the economic equation that we don’t have predictability. Even today, people are still arguing about what happened in 2008. So it’s even harder to look forward. [Look at] the role of the bond rating agencies in 2008, which is completely unreformed. Why would that be? Well, there must be a lack of consensus.

I like Bill Gates, but this is an example of how people worth $100 billion get listened to on subjects outside of their area of expertise. The physics analogy is silly, and proves exactly the opposite of what Gates assumes. “Macrophysics” (predicting complex physical systems such as hurricanes and earthquakes) does just as poor a job of prediction as macroeconomics.

Nonetheless, Gates is onto something here. Macroeconomics really does have problems that macrophysics does not, and “animal spirits” lies in the center of the confusion. While we cannot predict earthquakes and hurricanes with any precision, we do understand the forces that cause them. I’d argue that most economists don’t understand what caused the 2008 recession, even a decade later.

In my view, most American business cycles are caused by demand shocks, i.e., changes in current NGDP. And those demand shocks are caused by unstable monetary policy, i.e., changes in expected future NGDP. While most economists agree with my claim that US business cycles are mostly caused by demand shocks, they disagree on the claim that the root problem is unstable monetary policy.

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