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.
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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.
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.
Read Next: Financial Bubbles.
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