But this short-term solution has had long-term consequences. The watered-down version of The General Theory gained almost universal acceptance in the 1950s and 1960s. Yet this reduced version of Keynesian economics was also vulnerable to attack. During the 1970s a new generation of economists arose. In their critique, called the New Classical Economics, they saw that the few animal spirits that remained in Keynesian thought were too insignificant to have any importance in the economy. They argued that the original Keynesian theory had not been watered down enough. In their view, now the centrepiece of modern macroeconomics, economists should not consider animal spirits at all. So, not without a little irony, the old pre-Keynesian classical economics, without involuntary unemployment, was rehabilitated. The animal spirits had been relegated to the dustbin of intellectual history.

This New Classical view of how the economy behaves was passed from the economists to the think tankers, policy elites, and public intellectuals, and finally to the mass media. It became a political mantra: ‘I am a believer in free markets.’ The belief that government should not interfere with people in pursuit of their own self-interest has influenced national policies around the globe. In England it took the form of Thatcherism. In America it took the form of Reaganism. And from these two Anglo-Saxon countries it has spread.

This permissive-parent view of the role of government replaced the Keynesian happy home. Now, three decades after the elections of Margaret Thatcher and Ronald Reagan, we see the troubles it can spawn. No limits were set to the excesses of Wall Street. It got wildly drunk. And now the world must face the consequences.

It has been a long time since we discovered how it was possible for a government to offset the rational and irrational shocks that occur to capitalist economies. But as Keynes’ legacy and the role of government have been challenged, the system of safeguards developed from the experience of the Great Depression has been eroded. It is therefore necessary for us to renew our understanding of how capitalist economies – in which people have not only rational economic motives but also all kinds of animal spirits – really work.

The idea that economic crises, like the current financial and housing crisis, are mainly caused by changing thought patterns goes against standard economic thinking. But the current crisis bears witness to the role of such changes in thinking. It was causes precisely by our changing confidence, temptations, envy, resentment, and illusions – and especially by changing stories about the nature of the economy.

These intangibles were the reason why people paid small fortunes for houses in cornfields; why others financed those purchases; why the Dow Jones average peaked above 14,000 and a little more than a year later fell below 7,500; why the US unemployment rate has risen by 2.5 percentage points in the past twenty-four months, with the end of this rise not yet in sight; why Bear Stearns, one of the world’s leading investment banks, was only (and barely) saved by a Federal Reserve bailout, and why later in the year Lehman Brothers collapsed outright; why a large fraction of the world’s banks are underfunded; and why, as we write, some of them are still tottering on the brink, even after a bailout, and may yet be the next to go. And we know not what is yet to come.

This article is an exclusive excerpt (edited from preface) from the authors’ new book:
Animal Spirits. How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, published by Princeton University Press (ISBN 978-0-691-14233-3)

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