What Are Animal Spirits?

What Are Animal Spirits?

Let me explain what 'animal spirits' means in the world of economics. It's a term that captures the psychological and emotional elements that sway financial choices, especially when the economy is unpredictable. Economist John Maynard Keynes came up with this idea, pointing out how things like consumer confidence and fear can steer market behaviors and investor moves, ultimately impacting economic growth and stability. In this post, I'll dive into where it came from, why it matters, and some real examples in finance.

The phrase draws from the Latin 'spiritus animalis,' which translates to 'the breath that awakens the mind.' Keynes' take on human behavior essentially laid the groundwork for what we now call behavioral economics.

Key Concepts Behind Animal Spirits

You can trace the technical idea of spiritus animalis back to around 300 B.C., in studies of human anatomy and medical physiology. Back then, it referred to a fluid or spirit in the brain's sensory activities and nerve endings that could lead to widespread psychological events like manias or hysterias.

The term also popped up in literature, where it described states of physical courage, cheerfulness, and high energy. In that sense, animal spirits could be strong or weak based on someone's health and vitality.

How Animal Spirits Influence Financial Markets

In today's finance world, animal spirits show up in market psychology and behavioral economics. They embody emotions like confidence, hope, fear, and pessimism that can shape how you make financial decisions, either boosting or stalling economic growth. If spirits are down, confidence drops, and that can drag down even a strong market despite solid fundamentals. On the flip side, high spirits lift confidence and push market prices up.

Remember, animal spirits can spark asset price bubbles and trigger panic selling.

Emotional Drivers in Business Decision-Making

The theory says business leaders often rely on intuition and what their competitors are doing, not just hard analysis. Keynes knew that during economic turmoil, irrational thoughts can take over as people chase their financial interests.

In his book The General Theory, Keynes noted that estimating future yields from industries or companies using general knowledge often adds up to very little. He argued that in uncertain times, animal spirits are what guide your decisions.

Modern Perspectives on Animal Spirits

The term gained fresh attention in 2009 with the book by economists George A. Akerlof and Robert J. Shiller, titled Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.

They make the case that while animal spirits are key, governments need to step in with policies to keep them in check when needed. Without that, capitalism can spiral out of control, leading to excesses like the 2008 financial crisis.

Akerlof and Shiller outline five types of animal spirits: confidence, corruption, money illusion, fairness, and stories. These help economists tackle questions like why economies slip into depressions or why financial prices and investments swing so wildly.

Real-World Case Studies of Animal Spirits

Animal spirits often appear as market psychology fueled by fear or greed. Take 'irrational exuberance,' where investor hype drives asset prices way beyond their real value. During the Dotcom Bubble, just adding 'dotcom' to a company name inflated its value massively, even with no profits. The Nasdaq soared five times from 1995 to 2000, then crashed 76.81% to 1,139.90 by October 2002. By 2001, most dot-com stocks were worthless.

Another case is the buildup to the 2008-09 financial crisis and Great Recession. Markets buzzed with innovations like collateralized debt obligations, especially in housing. At first, it seemed positive, but these turned out to be fraudulent. Confidence vanished, sparking a sell-off and market plunge—a classic example of animal spirits gone wild.

Debating the Validity of Animal Spirits Theory

The idea is that investment prices rise and fall due to human emotions, not just intrinsic value. But critics, often from efficient market hypothesis supporters, say individual irrationality evens out overall, keeping markets efficient. Behavioral economics, including animal spirits, challenges those ideas of pure rationality.

Some blame bubbles on central banks and regulations, not crowd psychology, arguing that money supply hikes cause malinvestment. These views come from Austrian economics or libertarian perspectives.

The Bottom Line

John Maynard Keynes brought animal spirits into economics to show how emotions like confidence, hope, fear, and pessimism affect financial choices and market results. These factors drive consumer confidence and market psychology, creating bubbles or panic selling, and they question old ideas of rational, efficient markets. If you understand animal spirits, you get a better grasp on irrational market moves and why managing emotions matters in investing.