The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage. Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.
Aspect
Explanation
Definition
“Animal Spirits” is an economic concept introduced by economist John Maynard Keynes. It refers to the non-rational factors and emotions that influence economic decision-making and behavior, including consumer confidence, investor sentiment, and overall market psychology. These emotions can lead to fluctuations in economic activity, asset prices, and investment decisions that cannot always be explained by traditional economic models. Animal spirits represent the unpredictable and emotional aspects of economic decision-making that go beyond rational analysis and can have significant effects on economic outcomes.
Key Concepts
– Non-Rational Factors: Animal spirits encompass emotions and instincts that drive economic decisions. – Psychological Factors: They include consumer confidence, fear, optimism, and other psychological elements. – Impact on Markets: Animal spirits can influence asset prices, market volatility, and investment behavior. – Uncertainty: These non-rational factors contribute to economic uncertainty and unpredictability. – Herd Behavior: Herd behavior is a manifestation of animal spirits, where individuals follow the crowd rather than making independent decisions.
Characteristics
– Subjectivity: Animal spirits are subjective and can vary from person to person. – Irregular Behavior: They result in irregular and sometimes irrational economic behavior. – Market Sentiment: Market sentiment is heavily influenced by animal spirits, leading to booms and busts. – Feedback Loops: Positive or negative feedback loops can be created by emotional responses, amplifying market movements. – Unpredictability: Their impact is difficult to predict and model accurately.
Implications
– Market Volatility: Animal spirits contribute to market volatility and can lead to asset bubbles or crashes. – Consumer Spending: Consumer confidence influences spending patterns and can drive economic expansion or contraction. – Investor Behavior: Investors’ emotions can affect buying and selling decisions, impacting asset prices. – Policy Response: Policymakers may need to consider animal spirits when crafting economic policies. – Economic Cycles: They play a role in economic cycles, including recessions and recoveries.
Advantages
Animal spirits are not advantageous in themselves; they are a concept used to explain the complexity and unpredictability of economic behavior. However, recognizing their role in decision-making can help individuals and policymakers better understand economic dynamics.
Drawbacks
– Market Instability: Excessive animal spirits can lead to market instability and financial crises. – Misallocation of Resources: Irrational decisions driven by emotions can lead to the misallocation of resources. – Economic Uncertainty: They contribute to economic uncertainty and unpredictability. – Challenges for Policymakers: Policymakers may struggle to mitigate the impact of irrational behavior on the economy. – Behavioral Biases: Animal spirits are linked to behavioral biases that can distort economic outcomes.
Applications
The concept of animal spirits is applied in economics and finance to explain the impact of emotions, sentiments, and psychological factors on economic behavior and outcomes. It is particularly relevant in the study of financial markets, consumer behavior, and investor sentiment.
Use Cases
– Financial Markets: Analysts use the concept of animal spirits to understand market movements and asset price bubbles. – Consumer Behavior: Understanding consumer sentiment helps businesses adapt to changing market conditions. – Investment Strategy: Investors consider market sentiment and emotions when making investment decisions. – Economic Policy: Policymakers may use insights from animal spirits to design effective economic policies. – Behavioral Economics: Behavioral economists study animal spirits to explore the limits of rational decision-making in economics.
In an economic context, the term was first coined by British economist John Maynard Keynes in his 1936 publication The General Theory of Employment, Interest, and Money. In the publication, Keynes equates animal spirits with the emotions, instincts, and proclivities that impact human behavior and by extension, consumer confidence. Keynes used the term to describe the gloom and despondence that caused the Great Depression and the subsequent shift in psychology that accompanied the recovery.
Today, animal spirits encompass the psychological and emotional factors that drive investors to take action in volatile markets. Many of Keynes’ original insights have formed the basis of market psychology and behavioral economics.
Animal spirits in finance and economics
Keynes argued that economic performance was largely mental and not necessarily rational but emotional. Performance was also dictated by the level of investor confidence in the market.
When animal spirits are low, fear and pessimism cause low confidence which can hinder economic growth. This may occur regardless of whether economic or market conditions are fundamentally sound.
When animal spirits are high, hope and optimism cause high confidence which encourages economic growth. Market prices will soar, but again, the confidence level of the market may contradict the raw economic or market data.
In a 2009 book titled How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, authors George A. Akerlof and Robert J. Schiller suggested stories and storytelling were the drivers of market emotion and sentiment.
Stories, they argued, were fundamental to the way people think. Some research suggests successful marriages are attributable to the narrative each person tells about the relationship. What’s more, political leaders may live or die by the stories they tell voters. More to the point, stories inspire confidence (or a lack thereof) in economics.
In the next section, we’ll take a look at how these stories have influenced some of the biggest financial disasters in recorded history.
Animal spirits examples
Animal spirits can at least partly explain financial disasters including:
The Dotcom Bubble – a financial collapse instituted by the story of a new era heralded by the internet. Online company valuations rose to unprecedented levels thanks to the irrational exuberance and greed of investors.
The Wall Street Crash of 1929 – during the 1920s, stories of big market wins caused mass speculation in stocks. Many inexperienced investors borrowed money from brokers to purchase shares which caused mass bankruptcies when the market collapsed.
The Great Recession – investor confidence plummeted after it was discovered that collateralized debt obligations were found to be deceptive and fraudulent. Investment firms once considered robust went bankrupt and were associated with deceitful and corruptive practices. This narrative paralyzed surviving lenders who could not be certain that they would be repaid and hampered otherwise effective government policies to address the crisis.
Key takeaways:
The term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty. The phrase was coined in the economic context by British economist John Maynard Keynes.
Animal spirits describe the level of confidence in financial markets and their associated emotions. Fear and pessimism cause low market confidence, while hope and optimism cause high market confidence. In either scenario, there may be a disconnect between market sentiment and market or economic fundamentals.
Authors George A. Akerlof and Robert J. Schiller suggest stories and storytelling are the drivers of market emotion and sentiment. Stories explain investor behavior during financial crises such as The Dotcom Bubble and the Great Recession.
Key Highlights
Definition and Origin: The term “animal spirits” originates from the Latin “spiritus animalis,” representing the breath that awakens the human mind. Historically, it was used to explain psychological phenomena and appeared in literature to describe qualities like exuberance, gaiety, and courage. In an economic context, “animal spirits” describe how people make financial decisions during periods of economic uncertainty.
Coined by Keynes: British economist John Maynard Keynes introduced the term in his 1936 publication “The General Theory of Employment, Interest, and Money.” Keynes associated animal spirits with emotions, instincts, and proclivities that impact human behavior, including consumer confidence. He used it to explain the shifts in psychology during the Great Depression and subsequent recovery.
Psychological Factors in Finance and Economics:
Animal spirits encompass the psychological and emotional factors that drive investors to take action in volatile markets.
Economic performance is influenced by human emotions and confidence levels in the market, as argued by Keynes.
Low animal spirits driven by fear and pessimism hinder economic growth, while high spirits driven by hope and optimism encourage growth, irrespective of fundamental economic conditions.
Role of Stories and Narratives:
Authors George A. Akerlof and Robert J. Schiller highlighted the role of stories and storytelling in influencing market emotion and sentiment.
Stories are fundamental to human thinking and impact various aspects of life, including relationships and political perceptions.
Stories inspire confidence or lack thereof in economic scenarios.
Examples of Animal Spirits in Financial Disasters:
The Dotcom Bubble: Irrational exuberance and greed due to the narrative of a new internet era led to inflated online company valuations and subsequent collapse.
The Wall Street Crash of 1929: Stories of big market wins prompted mass speculation and inexperienced investors borrowing money, resulting in bankruptcies during the market collapse.
The Great Recession: Investor confidence plummeted due to fraudulent collateralized debt obligations, causing bankruptcy of once-robust investment firms and hampering government policies.
The idea of a market economy first came from classical economists, including David Ricardo, Jean-Baptiste Say, and Adam Smith. All three of these economists were advocates for a free market. They argued that the “invisible hand” of market incentives and profit motives were more efficient in guiding economic decisions to prosperity than strict government planning.
Positive economics is concerned with describing and explaining economic phenomena; it is based on facts and empirical evidence. Normative economics, on the other hand, is concerned with making judgments about what “should be” done. It contains value judgments and recommendations about how the economy should be.
When there is an increased price of goods and services over a long period, it is called inflation. In these times, currency shows less potential to buy products and services. Thus, general prices of goods and services increase. Consequently, decreases in the purchasing power of currency is called inflation.
Asymmetric information as a concept has probably existed for thousands of years, but it became mainstream in 2001 after Michael Spence, George Akerlof, and Joseph Stiglitz won the Nobel Prize in Economics for their work on information asymmetry in capital markets. Asymmetric information, otherwise known as information asymmetry, occurs when one party in a business transaction has access to more information than the other party.
Autarky comes from the Greek words autos (self)and arkein (to suffice) and in essence, describes a general state of self-sufficiency. However, the term is most commonly used to describe the economic system of a nation that can operate without support from the economic systems of other nations. Autarky, therefore, is an economic system characterized by self-sufficiency and limited trade with international partners.
Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.
Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.
An oligopsony is a market form characterized by the presence of only a small number of buyers. These buyers have market power and can lower the price of a good or service because of a lack of competition. In other words, the seller loses its bargaining power because it is unable to find a buyer outside of the oligopsony that is willing to pay a better price.
The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage. Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.
State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.
The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.
The paradox of thrift was popularised by British economist John Maynard Keynes and is a central component of Keynesian economics. Proponents of Keynesian economics believe the proper response to a recession is more spending, more risk-taking, and less saving. They also believe that spending, otherwise known as consumption, drives economic growth. The paradox of thrift, therefore, is an economic theory arguing that personal savings are a net drag on the economy during a recession.
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Rational choice theory states that an individual uses rational calculations to make rational choices that are most in line with their personal preferences. Rational choice theory refers to a set of guidelines that explain economic and social behavior. The theory has two underlying assumptions, which are completeness (individuals have access to a set of alternatives among they can equally choose) and transitivity.
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The term “knowledge economy” was first coined in the 1960s by Peter Drucker. The management consultant used the term to describe a shift from traditional economies, where there was a reliance on unskilled labor and primary production, to economies reliant on service industries and jobs requiring more thinking and data analysis. The knowledge economy is a system of consumption and production based on knowledge-intensive activities that contribute to scientific and technical innovation.
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The bottom of the pyramid is a term describing the largest and poorest global socio-economic group. Franklin D. Roosevelt first used the bottom of the pyramid (BOP) in a 1932 public address during the Great Depression. Roosevelt noted that – when talking about the ‘forgotten man:’ “these unhappy times call for the building of plans that rest upon the forgotten, the unorganized but the indispensable units of economic power.. that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyramid.”
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The L-shaped recovery refers to an economy that declines steeply and then flatlines with weak or no growth. On a graph plotting GDP against time, this precipitous fall combined with a long period of stagnation looks like the letter “L”. The L-shaped recovery is sometimes called an L-shaped recession because the economy does not return to trend line growth. The L-shaped recovery, therefore, is a recession shape used by economists to describe different types of recessions and their subsequent recoveries. In an L-shaped recovery, the economy is characterized by a severe recession with high unemployment and near-zero economic growth.
Comparative advantage was first described by political economist David Ricardo in his book Principles of Political Economy and Taxation. Ricardo used his theory to argue against Great Britain’s protectionist laws which restricted the import of wheat from 1815 to 1846. Comparative advantage occurs when a country can produce a good or service for a lower opportunity cost than another country.
The Easterlin paradox was first described by then professor of economics at the University of Pennsylvania Richard Easterlin. In the 1970s, Easterlin found that despite the American economy experiencing growth over the previous few decades, the average level of happiness seen in American citizens remained the same. He called this the Easterlin paradox, where income and happiness correlate with each other until a certain point is reached after at least ten years or so. After this point, income and happiness levels are not significantly related. The Easterlin paradox states that happiness is positively correlated with income, but only to a certain extent.
In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organizationscale further.
In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.
An economy of scope means that the production of one good reduces the cost of producing some other related good. This means the unit cost to produce a product will decline as the variety of manufactured products increases. Importantly, the manufactured products must be related in some way.
Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
