2 Finance & Development
June 2011
I
N 1984, economics Nobel laureate George Stigler pre-
dicted that economics was on its way to becoming the
queen of the social sciences. He called economics “an im-
perial science,” one that was clearing a path through the
academic thickets for other social disciplines. He applauded
the work of “economist-missionaries . . . often against appre-
hensive and hostile natives.”
Well a funny thing happened on the way to the coronation.
Over the quarter-century since Stigler’s article, it has become
clear that economics has as much to learn from other disciplines
as it has to teach them. Today, the field of behavioral finance uses
insights from psychology and sociology to understand financial
markets. Corporate scandals and greed-driven financial crises
have led to calls for blending ethics into economics. And Nobel
Prizes in economics over the past decade have gone to a psy-
chologist, daniel Kahneman (see F&D, September 2009), and a
political scientist, Elinor Ostrom.
These developments might have upset George Stigler but
not his namesake, George Akerlof, a 2001 economics Nobel
laureate. He says it has long been his “dream” to have a macro-
people IN ECONOMICS
The
Human
Face
of
economics
Prakash Loungani profiles George akerlof
Finance & Development
June 2011
3
economics grounded in the “full range of human emotions and
actions: fairness, confidence, greed, identity, procrastination.”
(Procrastination? We’ll get back to that . . . later.)
“it’s not fair!”
Akerlof says the topic that has motivated him the most over
his 40-year career is unemployment. “I have always thought
of unemployment as a terrible thing. In fact that has been the
motivation for almost everything I have ever written. A person
without a job loses not just his income but often the sense that
he is fulfilling the duties expected of him as a human being.”
Why does unemployment arise? Akerlof, in joint work
with noted economist Janet Yellen (who also happens to be
his wife), has argued that the notion of fairness plays a key
role. Akerlof and Yellen draw on sociology to enrich the
description of how exchange takes place in markets, includ-
ing the labor market. In economic theory, the price at which
an exchange takes place is determined by supply and demand.
If more sellers bring fruit to a farmers’ market than there are
buyers that day, the price at which fruit is sold drops. If there
is an unexpected snowstorm, a hardware store, according to
the economic theory, will raise the price of shovels and is jus-
tified in doing so to reflect their sudden scarcity.
But “human beings don’t always think this way,” says Akerlof.
Surveys have shown that people regard it as unfair if hardware
stores raise prices in the middle of a snowstorm. And prices
may not always fall in the farmers’ market when supply out-
strips demand. People who shop in farmers’ markets are often
“making a statement,” Akerlof says. Some buyers may buy a bit
more than they had planned if they see the sellers they are try-
ing to support not doing too well. And some sellers may have
too much “pride in the quality [of their product]” to lower the
price and may hold out for a price they regard as “fair.”
When applied to the labor market, considerations of fair-
ness play an even more important role. The price at which
labor is exchanged—the wage rate—does not depend solely
on the demand and supply of labor. The employer has to fac-
tor in the impact of paying a low wage on the morale and effi-
ciency of the worker. It does no good for an employer to drive
down a worker’s wage if that would cause the worker to be
resentful and to figuratively “spit in the soup.” Hence employ-
ers offer something higher than the wage that would equate
demand and supply. Akerlof and Yellen call this the “effi-
ciency wage” to capture the notion that higher wages moti-
vate workers to be more effective or efficient at their jobs.
The aggregate consequence of employers doing the right
thing is that there will always be some unemployment in the
economy, because wages will be set higher than the rate at
which everyone who seeks a job would be employed. “The
market for jobs is then like a game of musical chairs, with
more people on the dance floor than there are chairs. When
the music stops, some people cannot find a chair,” Akerlof
has written (Akerlof and Shiller, 2009).
animal spirits
Akerlof says that trying to understand unemployment—“why
supply doesn’t always equal demand in labor markets”—has
also helped him think in a more broad-minded way about
how “people, organizations, markets, and capitalism” really
work. This creative thinking is reflected in Akerlof’s 2009
book Animal Spirits (see F&D, december 2008)—written
jointly with Yale University economist robert Shiller—which
was short-listed for the Financial Times/Goldman Sachs
Business Book of the Year Award. Shiller told F&D that in
the process of writing the book, the views of the two authors,
already close, blended further, so that “I can no longer iden-
tify reliably who wrote what.” The book, he says, reflects “our
view that the social sciences should be more united.”
Akerlof and Shiller demonstrate how forces not generally
considered in standard macroeconomics—such as fairness,
greed, and confidence—are critical to understanding not
just why there is unemployment but also why economies fall
into recession and why asset markets are so volatile. They
are particularly keen to resurrect the importance the great
British economist John Maynard Keynes assigned to the role
of confidence in economic fluctuations, most notably in his
assertion that business investment depends significantly on
the state of confidence or on “animal spirits.” “The state of
confidence,” Keynes wrote, “is a matter to which practical
men always pay the closest attention. But economists have
not analyzed it carefully.”
Investment decisions by businesses and households’ choice
of how much to consume today versus how much to save for
the future are driven by uncertain and fluctuating expecta-
tions of what the future holds. Keynes argued that “this feel-
ing of uncertainty waxes and wanes: sometimes people are
more confident than at others. When confidence is high,
the economy thrives; when it is low, it sickens.” Indeed,
overconfidence can spur excessive and foolish investment,
for instance in housing markets. The collapse of optimistic
expectations can thus lead to a collapse of the economy. And
when the economy is down, loss of confidence can cause an
overreaction in the other direction, with credit drying up and
consumers retrenching.
Akerlof points to the 1991 recession in the United States as
an example of the importance of confidence. He remembers
a session at the American Economic Association meetings in
1992 where leading economists went through the usual roster
of explanations for the recession. None fit. The best explana-
tion was the one offered by Olivier Blanchard, then at MIT
but now the IMF’s chief economist, who said that the inva-
sion of Kuwait by Saddam Hussein had delivered a blow to
U.S. consumer confidence and hence to consumption expen-
ditures. “Olivier’s explanation was simple but it was right,”
says Akerlof. “Or at least I don’t know of an explanation that
fits the main facts better.”
“The combination of daring
questions and beautiful answers is
what makes George the successful
contrarian he is.”
4 Finance & Development
June 2011
Happy home
With the private economy subject to mood swings, the role
of the government is to stabilize the economy through its
actions. The government, Akerlof and Shiller state, should be
like a responsible parent to the economy, neither too authori-
tarian nor too permissive. Capitalist societies can be tremen-
dously creative, and the government should not be so strict as
to interfere with that creativity. But capitalism left to its own
devices also runs to excess, and the government’s role is to act
as a countervailing force against extravagance.
So when the private economy is booming, the govern-
ment must guard against euphoria and it must save for the
likely collapse. And when private confidence is low, the gov-
ernment must carry out public investment. Indeed, Keynes
famously argued that even digging ditches and refilling them
was a worthwhile activity for the government when the pri-
vate sector is in the doldrums. Akerlof says it “should not
come to that. There are many more worthwhile things that a
government can do to create a confidence multiplier” to get
the economy back on track.
The government also has a role in preventing corruption
and predatory activity. In a famous paper written in 1993,
Akerlof and his coauthor, economist Paul romer, dispensed
with the euphemisms and simply called it “looting.” The
paper was written in the aftermath of a spate of financial cri-
ses during which private investors left the government with
the responsibility for extensive debt. Akerlof says, “of course
we were very much motivated by the savings and loan crisis”
in the United States in the early 1990s.
Akerlof and romer wrote that the savings and loan “fiasco”
occurred because regulators hid the true extent of the prob-
lem, Congress pressured regulators to go easy on favored
constituents and big donors, and lobbyists succeeded in pre-
venting corrective action until the problem was so large it
had to be passed on to the general public. They concluded
that “now we know better. If we learn from experience, his-
tory need not repeat itself.”
Unfortunately, events since Akerlof and romer wrote their
paper read, as david leonhardt put it in The New York Times,
“like a sad coda to the ‘looting’ paper.” In the early 2000s,
scandals engulfed corporations like Enron. Inadequate regu-
lation of subprime lending and outright fraud are now widely
accepted to have been a trigger for the global financial crisis
and the Great recession of 2007–09. romer now recalls that
just as they were done writing their paper in 1993, Akerlof
told him that the next candidate for looting would be an
obscure little market called “credit derivatives.”
Asked to summarize his view of government policies over
the past 30 years, Akerlof says with characteristic understate-
ment: “let’s just say that the government has had mixed suc-
cess in creating a happy home.”
ivy league
In his 2001 Nobel lecture, Akerlof describes his own life as
a child and young man as mostly a happy one, but subject
to the vicissitudes of his father’s career. Akerlof remem-
bers thinking that “if my father lost his job, and my family
stopped spending their money, then another father would
lose their job and so on. The economy would spiral down-
ward.” Worries about his father’s job prospects may explain,
he wrote in the lecture, why “in some sense I began work on
unemployment theory when I was 12. Fifty years later I am
still mulling over the same subject.”
Akerlof went to Yale for his undergraduate education;
he had “no choice,” he says, because his father had been
an assistant professor there and his brother went to Yale as
well. In addition to taking courses in economics and math,
he worked on the Yale Daily News. He says it “dominated his
life.” He tried to make the News less of an official organ and
more of a newspaper devoted to student issues and features
of human interest: “I wanted it to be less solemn and more
serious.” despite his enthusiasm and hard work, however, he
was denied election to the News board in his junior year.
In his Nobel lecture, he said that this denial may have been
because “I am not accurate regarding facts.” But Akerlof told
F&D that his “statement [in the lecture] perhaps leaves a wrong
impression about me.” He says that he is careful with the “facts
that matter” and that his research has always been guided by
trying to explain facts: “Why is there unemployment? Why do
people report that they have trouble selling their houses? Why
are some people poor? Why do people procrastinate? Why do
people act up? Why do entire nations act up?”
After Yale, Akerlof headed for graduate work at MIT, which
boasted a cast of stellar professors, such as robert Solow (see
F&D, March 2011), and brilliant students—including Joseph
Stiglitz (see F&D, december 2009), who later shared the
Nobel Prize with Akerlof. Princeton University’s Avinash
dixit (see F&D, december 2010), also a contemporary of
Akerlof’s at MIT, says that “[George] posed questions that no
one else would. And just when you were thinking that only
a damn fool would ask a question like that, he produced a
beautiful answer that changed your perspective . . . The com-
bination of daring questions and beautiful answers is what
makes George the successful contrarian he is.”
Berkeley bound
Since 1966, much of Akerlof’s career has been as a profes-
sor at the University of California, Berkeley. As with Yale,
there is a family association; his great-grandfather gradu-
ated from Berkeley in 1873. When he won the Nobel in 2001,
Akerlof gave the prize money to Berkeley: “I did that because
I felt that they had supported me well and I wanted to show
how grateful I was.” Christina romer, a fellow professor at
Berkeley, says that “George is a kind, generous, and enthusi-
astic person who loves economics. He contributes immeasur-
ably to the department by simply being the kind of person
he is.” She adds that his “teaching evaluations are simply off
the charts.” Shiller says that Akerlof is like a father toward the
graduate students he supervises: “He advises them to be nice
Unemployment is the topic that has
motivated him the most.
Finance & Development
June 2011
5
when they go on the job market. The people interviewing
you are hiring you to be a colleague, he tells them, and they
want to see that you are a nice person.”
While an academic at heart, Akerlof has maintained close
links with the policy world. during the 1970s, he worked
for a year each at the Council of Economic Advisers (CEA)
and the Federal reserve. Barry Chiswick, a labor economist
and currently department chair at The George Washington
University, was at the CEA at the same time. In his Nobel
lecture, Akerlof credits Chiswick with teaching him empiri-
cal economics. Chiswick tells F&D that “it is very gracious of
George to have said that,” but “it was a two-way street—All
of us at CEA learned from George’s unique basket of skills.”
He recalls Akerlof as being very engaged with the issue of
teenage unemployment, a problem in the 1970s as it is today.
“George was concerned that if young people miss out and
don’t get a good first job that it would be taken as a negative
signal that could affect them for life,” says Chiswick.
In addition to these stints at U.S. government agencies,
Akerlof has maintained a long-term association with the
Brookings Institution. Since September 2010 he has been a
senior resident scholar in the IMF’s research department.
Blanchard says that “having George in our midst would be a
boon at any time; but his presence is particularly welcome at
the moment, when the IMF needs creative thinking on many
fronts, from tackling the unemployment crisis to the design
of financial regulation.”
lemons
While unemployment is the topic that has motivated him the
most, it is his 1970 article showing how markets might break
down in the presence of asymmetric (or unequal) informa-
tion that won him the Nobel Prize. Indeed, if you play a
game of word association with an economics Phd and say
“Akerlof,” chances are the response will be “lemons.” This is
because the example Akerlof gave was of used car markets,
where sellers have better knowledge of whether their car is a
good one or a “lemon.” The buyers’ best guess is that the car
is of average quality, so they will only be willing to pay the
price of a car of average quality. This means, however, that
owners of good cars will not place their cars in the used car
market. But that in turn lowers the average quality of cars on
the market, causing buyers to revise downward their expecta-
tions of quality. Now even owners of moderately good cars
are unable to sell, and so the market spirals toward collapse.
Akerlof says that the problem dates back to one that has
confronted horse traders over the ages: “If he wants to sell
that horse, do I really want to buy it?” But problems of asym-
metric information are present in most markets, particularly
in financial markets. “This [recent financial] crisis gave us
glaring examples,” says Akerlof. “Ordinary people thought
they were buying homes, not the complex derivatives that
they later realized they had ended up buying.”
Akerlof says he chose the example of used cars to make his
paper “more palatable” to U.S. readers. But his interest in the
subject had been triggered when, during his stay in India in
1967–68, he noticed people’s difficulty obtaining credit. He
kept this example in the paper, along with sections on how
the “lemons principle” could also explain why the elderly
had trouble obtaining insurance and why minorities had
difficulty obtaining employment. All this proved too exotic
for much of the academic market of the time; the paper was
turned down by three leading journals before it was finally
published in the Quarterly Journal of Economics.
Today, the questions Akerlof tackled in the “lemons” paper
are a staple of the academic diet. And Akerlof himself con-
tinues to push the frontiers on the study of such questions,
most recently in Identity Economics, coauthored with rachel
Kranton, then at the University of Maryland. Akerlof’s son,
robby, carries on the tradition. A graduate of Yale—where
Shiller was one of his professors—and Harvard, he is study-
ing questions such as why corruption and the tolerance of it
vary across corporations; what managers can do to increase
the legitimacy of their authority (paying efficiency wages
turns out to be one option); what accounts for an oppo-
sitional culture where minorities disparage the majority
and are disparaged in turn; and what fuels protracted feuds
between two parties.
oh finally!
So here at long last is the procrastination story. Akerlof wrote
a 1991 essay, “Procrastination and Obedience,” in which he
argues that studying the habit could explain phenomena such
as substance abuse and inadequate savings.
In the essay, Akerlof tells of having procrastinated for over
eight months before sending back a box of clothes from India
to the United States. The box belonged to Joseph Stiglitz, who
had left it behind in India when visiting. “Each morning . . .
I woke up and decided that the next day would be the day to
send the Stiglitz box,” Akerlof wrote. reflecting on the story,
Akerlof told F&D that “on things that really matter” he is not
a procrastinator.
“Joe didn’t really need his box. If I had thought he needed
it, he would have got it.” n
References:
Akerlof, George A., 1970, “The Market for ‘Lemons’: Quality
Uncertainty and the Market Mechanism,” Quarterly Journal of
Economics, Vol. 84, No. 2, pp. 488–500.
———, 1991, “Procrastination and Obedience,” American Economic
review, Vol. 81, No. 2, pp. 1–19.
———, and Rachel E. Kranton, 2010, Identity Economics: How Our
Identities Shape Our Work, Wages, and Well-Being (Princeton, New
Jersey: Princeton University Press).
Akerlof, George A., and Paul M. Romer, 1993, “Looting: The Economic
Underworld of Bankruptcy for Profit,” Brookings Papers on Economic
Activity, Vol. 24, No. 2, pp. 1–73.
Akerlof, George A., and Robert J. Shiller, 2009, Animal Spirits: How
Human Psychology drives the Economy, and Why It Matters for Global
Capitalism (Princeton, New Jersey: Princeton University Press).
Akerlof, George A., and Janet Yellen, 1988, “Fairness and
Unemployment,” American Economic review, Vol. 78, No. 2, pp. 44–49.
Leonhardt, David, 2009, “The Looting of America’s Coffers,” The New
York Times, March 10.
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