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Legal Commentary

: Adam Smith, Esq.

What I'm Reading


From time to time, people ask me what I'm reading when trying to figure out what is going on in the economy these days. A glib response might be, "anything I can get my hands on," but the question deserves a more thoughtful response, so herewith a book review and a few pointers to online sites that are more helpful than most.

The online sites, first as they're easy to handle in a condensed fashion:

  • David Warsh's Economic Principals is perhaps the single most studious, well-written, thoughtful, and occasionally (but not doctrinally) contrarian site I know of. David publishes on a faithful, if quaint, once-a-week schedule, just like the print journalist he was, with provocative pieces such as "More than two aspirin," and "What comes after a golden age?."
  • Truth on the Market bills itself as 'academic commentary on law, business, economics, and more," and it's surely worth checking out for that promise alone. While uneven at times, at its best it can be great fun.
  • Matrix (on interpreting the real estate economy, with a focus on New York City) is a remarkably wide-ranging and thoughtful site covering the industry that's arguably at the root of all our evil woes, written by Jonathan Miller, who is the gold standard of appraisers in the New York City market.
  • Academic Earth bills itself as "thousands of video lectures from the world's top scholars."  And it is.  Origins of the Financial Mess (Alan Blinder, Princeton) is a good place to start.
  • Marginal Revolution talks about a wide variety of topics in an often irreverent tone. A current post about the AIG bonus PR nightmare consists in its entirety of:

    Outrage, outrage, blah, blah, blah, etc. Often I feel that some topics are too obvious to blog.
    The real lesson is that this is another reason not to nationalize banks. It means politicizing every decision which ends up in the newspaper.
    Here is a good post on why the bonuses should be paid.
    Outrage, outrage, blah, blah, blah, etc.

But forthwith to the book review.

Animal Spirits, by George Akerloff (Nobel Prize Winner in Economics) and Robert Shiller, father of the famous Case-Shiller real estate index, was reviewed in the Financial Times:

[The authors] argue that the key is to recover Keynes's insight about 'animal spirits'--the attitudes and ideas that guide economic action. The orthodoxy needs to be rebuilt, and bringing these psychological factors into the core of economics is the way to do it. . . . The connections between their thinking on the limits to conventional economics and the issues thrown up by the breakdown are plain, even if they were unable to make every link explicit. Even more than Akerlof and Shiller could have hoped, therefore, it is a fine book at exactly the right time. . . . Animal Spirits carries its ambition lightly--but is ambitious nonetheless. Economists will see it as a kind of manifesto.

What are "animal spirits," again?  The most concise explanation was actually provided by a reviewer on Amazon:

In his epoch-making General Theory of Employment, Interest, and Money (1936), John Maynard Keynes noted that concerning investment decisions, "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." Because of this propensity of investors to base decisions on variables other than "market fundamentals," the aggregate investment function of an economy will tend to be highly variable and erratic. Indeed, even today, it is virtually impossible to predict aggregate investment successfully, although the other sources of aggregate demand and supply are relatively well understood.

The book explores, in its Part I, five different dimensions of animal spirits and how they affect the economy: 

  • Confidence
  • Corruption
  • The "money illusion" (basically, people's propensity to ignore modest levels of inflation and deflation and to believe in a constant value of money)
  • "Stories" which can mislead (for example, "the Internet will revolutionize everything..."); and
  • Lack of perceived fairness (for example, AIG bonuses).

Part II, in turn, looks at some consequences of animal spirits' role in economic decision-making, and how they can help explain the answers to such questions as:

  • Why do economies suffer depressions?
  • What's to be done about the current financial crisis?  (Caveat:  Events are moving so quickly on this front that the authors' discussion is already looking quite dated.)
  • Why can some people not find a job?
  • Why is saving for the future so arbitrary?
  • Why are financial prices and corporate investments so volatile?

The most valuable aspect of the book is that the authors show how human decisionmaking—as it's really performed, animal spirits and all—violates the classic notion of purely rational homo economicus.  Consider this thought experiment they offer:

  Economic Non-economic
Rational, economic decisions
Rational, non-economic decisions
Non-rational, economic decisions
Non-rational, non-economic decisions

Of course, neoclassical economic theory essentially addresses only the top left cell, whereas animal spirits help inform our understanding of the other three cells.  Actually, I would argue that we can ignore the entire right hand column for present purposes, since it's by hypothesis in the realm of the "non-economic," but even if you wipe that from the attention of your cortex, the bottom left quadrant is clearly where a lot of the fascinating debate today around "fairness" (AIG bonuses again), "moral hazard," "fragility," "systemic risk," and so forth revolves.

Indeed, our again-helpful Amazon reviewer, who has simulated the behavior of individuals in markets, reports:

There is nothing in economic theory that says that rational individuals interacting on markets will produce stable, efficient outcomes. The Walrasian general equilibrium model says that if there are no market externalities, there are market-clearing equilibria that are Pareto-efficient, but this model has absolutely NO attractive dynamical properties. When I subjected this model to an agent based simulation (Herbert Gintis, "The Dynamics of General Equilibrium", Economic Journal 117 2007:1289-1309), I found that there is a robust tendency towards market clearing equilibrium, but this is always offset by highly volatile stochastic movements in prices, wages, capital demand, and other macroeconomic variables. This stochasticity is due to the fact that the macroeconomy is a complex, nonlinear, dynamical system, not because of "animal spirits."

Jargon patrol:  A "Walrasian equilibrium" essentially means a competitive environment and not one populated by players with market power.  "Externalities" are costs imposed upon, or benefits enjoyed by, actors not participating in the market in question.  "Pareto-efficient" means that there is no possible change which would leave every player no worse off and at least one player better off.

The fascinating point here is that a core result is "always" "highly volatile stochastic [random] movements in [key] macroeconomic variables." 

And isn't that just what we've seen in the subprime meltdown and its aftermath?

The really stunning fact about the current macroeconomy is that disequilibrium in the home mortgage market could so seriously compromise the American financial system. Even those who foresaw the housing crisis did not predict so massive and credit collapse, leading to levels of government intervention that would have been inconceivable in the past.

Animal Spirits is without doubt an intriguing, thoughtful, and timely book (and a quick read as well at 264 pages including notes and index), but I fear that its very focus on the quirkiness of human decision-making might serve as a pleasant distraction from the core and unavoidable truth that under- or improperly regulated markets cannot be counted upon to produce economically or socially desirable results.

Given the general level of surprise and intellectual shock that have accompanied this global meltdown,, it has become increasingly common to hear calls for a "new capitalism" or for some inchoate reworking of the received canon of wisdom in economics to help us navigate these seemingly unprecedented times.

If you're tempted, as I admit I occasionally have been, to pursue this path, I commend to you Amartya Sen's Capitalism Beyond the Crisis in the March 26,2009 issue of The New York Review of BooksSen was the 1998 Nobelist in economics for his contributions to "welfare economics,"  ("Welfare economics," roughly speaking, is the branch that concerns allocative efficiency within a society, income distribution, and—you guessed it—achieving Pareto-optimal results.)

Sen's article is, by and large, an effective effort to debunk the mythologies that have been attributed, for motives base and innocent alike, to the Big Thinkers in economics including Adam Smith and John Maynard Keynes.  Perhaps we should not be surprised that the imprimatur of these legendary names would be appropriated for ideological or expedient means, but it's worth going back to what they actually said, as Sen does, to realize that we may have the blueprint for recovery in front of us if only we choose to see it. 

Here is Sen on the "public/private mix" that undergirds all of today's First World economics.  Forgive the somewhat lengthy excerpts, but Sen's argument is subtle and his prose pleasant:

What are the special characteristics that make a system indubitably capitalist--old or new? If the present capitalist economic system is to be reformed, what would make the end result a new capitalism, rather than something else? It seems to be generally assumed that relying on markets for economic transactions is a necessary condition for an economy to be identified as capitalist. In a similar way, dependence on the profit motive and on individual rewards based on private ownership are seen as archetypal features of capitalism. However, if these are necessary requirements, are the economic systems we currently have, for example, in Europe and America, genuinely capitalist?

All affluent countries in the world--those in Europe, as well as the US, Canada, Japan, Singapore, South Korea, Australia, and others--have, for quite some time now, depended partly on transactions and other payments that occur largely outside markets. These include unemployment benefits, public pensions, other features of social security, and the provision of education, health care, and a variety of other services distributed through nonmarket arrangements. The economic entitlements connected with such services are not based on private ownership and property rights.


[T]he pioneering works of Adam Smith in the eighteenth century showed the usefulness and dynamism of the market economy, and why--and particularly how--that dynamism worked. Smith's investigation provided an illuminating diagnosis of the workings of the market just when that dynamism was powerfully emerging. The contribution that The Wealth of Nations, published in 1776, made to the understanding of what came to be called capitalism was monumental. Smith showed how the freeing of trade can very often be extremely helpful in generating economic prosperity through specialization in production and division of labor and in making good use of economies of large scale.

Those lessons remain deeply relevant even today (it is interesting that the impressive and highly sophisticated analytical work on international trade for which Paul Krugman received the latest Nobel award in economics was closely linked to Smith's far-reaching insights of more than 230 years ago).


Even though people seek trade because of self-interest (nothing more than self-interest is needed, as Smith famously put it, in explaining why bakers, brewers, butchers, and consumers seek trade), nevertheless an economy can operate effectively only on the basis of trust among different parties. When business activities, including those of banks and other financial institutions, generate the confidence that they can and will do the things they pledge, then relations among lenders and borrowers can go smoothly in a mutually supportive way. As Adam Smith wrote:

When the people of any particular country have such confidence in the fortune, probity, and prudence of a particular banker, as to believe that he is always ready to pay upon demand such of his promissory notes as are likely to be at any time presented to him; those notes come to have the same currency as gold and silver money, from the confidence that such money can at any time be had for them.[1]

Smith explained why sometimes this did not happen, and he would not have found anything particularly puzzling, I would suggest, in the difficulties faced today by businesses and banks thanks to the widespread fear and mistrust that is keeping credit markets frozen and preventing a coordinated expansion of credit.

It is also worth mentioning in this context, especially since the "welfare state" emerged long after Smith's own time, that in his various writings, his overwhelming concern--and worry--about the fate of the poor and the disadvantaged are strikingly prominent. The most immediate failure of the market mechanism lies in the things that the market leaves undone.

And here, if you will, is the punch line:

Smith called the promoters of excessive risk in search of profits "prodigals and projectors"--which is quite a good description of issuers of subprime mortgages over the past few years. Discussing laws against usury, for example, Smith wanted state regulation to protect citizens from the "prodigals and projectors" who promoted unsound loans:

A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it.[4]

The implicit faith in the ability of the market economy to correct itself, which is largely responsible for the removal of established regulations in the United States, tended to ignore the activities of prodigals and projectors in a way that would have shocked Adam Smith.

The present economic crisis is partly generated by a huge overestimation of the wisdom of market processes, and the crisis is now being exacerbated by anxiety and lack of trust in the financial market and in businesses in general.

Sen also writes that unappreciated in the current crisis is the relevance of Arthur Cecil Pigou (a contemporary of Keynes, also at Cambridge and also in fact at King's College).  Whereas Keynes viewed the economy primarily through a mechanistic and hydraulic lens (the value of the famous "multiplier" being a primary example), Pigou put his focus on psychology, where Sen (and yours truly) believe it belongs.  At the root of economic fluctuations, Pigou wrote, were "psychological causes," namely "variations in the tone of mind of persons whose action controls industry, emerging in errors of undue optimism or undue pessimism in their business forecasts.[5]"  Sen goes as far as to say that "the real crisis...has become many times magnified by a psychological collapse," and he scarcely overstates the case.

Perhaps we should conclude with the culminating irony of this short tour of the landscape of Fabled Economists:  It is that while Smith and Pigou are traditionally seen as "conservative," and Keynes as something of a rebel, the first pair were far more outspoken, insightful, and insistent upon the importance of non-market institutions and non-profit values.

What else am I reading? Alpha by author:

  • Geoff Colvin's Talent is Overrated:  What Really Separates World-Class Performers from Everybody Else.  This book, based soundly in empirical research, delivers the hard message that true excellence depends upon hours and hours (10,000 hours, to be precise) of "deliberate practice"—be it the young Mozart composing, the young Tiger Woods practicing, or any aspiring concert violinist.  The same, by extension, is true of surgeons, mathematicians, CFO's—and lawyers and writers.  As Colvin puts it, this is good news and bad news:

    "What would cause you to do the enormous work necessary to be a top-performing CEO, Wall Street trader, jazz, pianist, courtroom lawyer, or anything else? Would anything? The answer depends on your answers to two basic questions: What do you really want? And what do you really believe? What you want - really want - is fundamental because deliberate practice is a heavy investment."

  • Jerry Coyne's Why Evolution Is True.  Demolishes creationism and "intelligent design"—and then intellectually carpet-bombs them again, to make sure "the rubble bounces," as Churchill described the goal of a particular bombing campaign in WWII—but does so with respect and patience.  I can do no better than to repeat the aphorism that "Nothing in biology makes sense except in the light of evolution."  Coyne explains why, and brings you up to date on recent developments in this endlessly fascinating science in the bargain.

  • Niall Ferguson's The Ascent of Money: A Financial History of the World:  Ferguson recapitulates the history of money from the pre-Christian era through today's subprime meltdown and global credit freeze, noting that bubbles are as much a part of economic history as are booms and concluding with a warning that excessively precautionary regulation  cannot and should not remove the possibility of extinction for institutions which are weak.  That is to say, financial crises should and must result in casualties.  Or, as Joseph Schumpeter put it in The Theory of Economic Development (1934):  "This economic system cannot do without the ultima ratio of hte complete destruction of those existences which are irretrievably associated with the hopelessly unadapted."

  • Dexter Filkins' The Forever War  A harrowing account of the "war on terror" from the rise of the Taliban in the 1990's through virtually today in Iraq and Afghanistan, by one of the New York Times' star reporters.

  • Michael Lewis' Panic:  The Story of Modern Financial Insanity, a tour de horizon of recent financial embarrassments, using the tool of reproducing contemporaneous (and a few subsequent) accounts and analyses, and covering the collapse of Long Term Capital Management, the Asian financial crisis of the 1990's, the dotcom meltdown, and early warning signals of our present distress.  Plus c'est change.

  • Jessica Livingston's Founders at Work:  Stories of Startups' Early Days.  The stories of mostly legendary (and a few relatively obscure) entrepreneurs, told in their own words through extensive interviews, about the early days at their would-be companies, including:  Max Levchin/PayPal, Steve Wozniak/Apple, Mike Lazaridis/Research in Motion, Mike Ramsay/Tivo, Charles Geschke/Adobe, and Ron Gruner/Alliant Computer.  Utterly charming.  And the moral?  (1)  Expect the unexpected.  (2) And meet it with persistence

  • Daniel Pink's A Whole New Mind:  Why Right-Brainers Will Rule the Future.  Pink's thesis, fairly widely adopted today, is that human economic organization has moved from the agricultural to the industrial to the information and now to the conceptual age, where the value is on those individuals and firms capable of integrating empathy, meaning, design, and a narrative (a/k/a "story") to their products and services.  If you or your firm can't master those skills, beware of "Asia, Abundance, and Automation."

  • Robert Samuelson's The Great Inflation and Its Aftermath:  The Past and Future of American Affluance.  An economic and political history of what is now a curiously forgotten period, the "great inflation" of the 1970's and early 1980's, famously cut off at the knees, along with much economic activity, by Paul Volcker and Ronald Reagan in the 1981-'82 recession.  Not, perhaps, a deep or subtle read, but a fascinating and thorough portrayal of, as I say, an oddly invisible era.


Full post as published by Adam Smith, Esq. on March 23, 2009 (boomark / email).

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