Arguments that invoke “animal spirits” appeal to Keynesian economists (who favor deficit spending to create jobs).  But discussions of animal spirits do not help us with the question of how much debt is prudent for the US economy.

In a recent New York Times column (“The Survival of the Safest,” October 3, 2010), Robert J. Shiller argues that the government should step in to boost the “animal spirits” of the American people.  His thesis is as follows: 

“Damage to morale – which John Maynard Keynes called ‘animal spirits’ – surely ranks as one of the most important reasons for the American economy’s persistent weakness.”

Shiller explains that mass layoffs have spread anger and distress throughout thousands of communities.  Citing the work of his colleague Truman Bewley, Shiller reasons that remaining workers are suffering from “survivor’s guilt,” which leaves them cautious, risk-averse, and frugal, and which makes mangers reluctant to spend on buildings, equipment, and software.  Without stronger consumer demand or business spending, the economy is stuck grinding along too slowly to bring down unemployment, and we risk slipping into what could become a “downward spiral.”

To address this problem, Mr. Shiller calls for greater government spending:  “Sometimes the private sector needs help from the government, and this is one of those times.  We need to break the cycle of protracted unemployment and sagging morale through big government programs to create millions of jobs.”  This is an echo of the great economist John Maynard Keynes’ call for deficit spending during cyclical downturns.

However, there are two logical problems with Shiller’s recommendation and more broadly with Keynesian logic:

First, if Shiller thinks that “animal spirits” should be higher today, then he must not see a link between people’s attitudes and their experiences, as if animal spirits are supposed to always be high and never waiver.  Yet there is nothing irrational about the current mood.  The US has recently endured the toughest economic downturn since the Great Depression.  Not surprisingly, people have adjusted their attitudes from the free-wheeling ways that prevailed during boom times.  We’ve been reminded that in a volatile world, holding more cash in reserve is prudent and rational.  This means less spending and more saving, until consumers and business have rebuilt their reserves.

Of course, if caution and frugality are the new norm, then the economy will necessarily grind along slowly, until people and businesses have rebuilt enough reserves to feel comfortable again spending and taking risks.  During this period, unemployment will remain a problem, as will the anger and distress suffered by millions of unemployed, as Shiller rightly points out.  But even so, this brings us to the second flaw in Shiller’s solution:  influencing the people’s animal spirits through massive job creation is costly.  Shiller does not address the limits to any government’s ability to borrow and spend. 

To create millions of jobs, as Shiller advocates, would require the U.S. government to operate with an even larger deficit, and this would necessitate issuing more debt.  When governments issue too much debt, they raise the probability of inflation, currency depreciation, or sovereign default.  No doubt the governments of Greece, Spain, Ireland, Portugal, and many others would like to boost their populations’ animal spirits through job creation programs.  But no-one will lend them the money to do so.  Further deficit spending is not possible for them, and hence Keynesian logic does not work.

We are fortunate that the US government still has the capability to issue debt, which allows us to balance the pain of the unemployed against the risk of higher leverage.  But let’s stop to think before we follow Shiller’s call to reinvigorate animal spirits.  In a volatile world, the safest may indeed be among the survivors.