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.
|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.|
Understanding animal spirits
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.
- 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.
- 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.
Read Next: Financial Bubbles.
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