What does 'Animal Spirits' mean
Animal Spirits is a term used by John Maynard Keynes to explain why decisions are made even in times of uncertainty. In Keynes’ 1936 publication, The General Theory of Employment, Interest and Money, the term "animal spirits" is used to describe human emotion that drives consumer confidence.
Animal spirits is gotten from the Latin term spiritus animalis which means the breath that awakens the human mind.
BREAKING DOWN 'Animal Spirits'
The technical concept of animal spirits or spiritus animalis goes as far back as 300BC where the term was used in human anatomy and physiology in medicine. It referred to the fluid or spirit that was responsible for sensory activities and nerves in the brain. Besides the technical meaning in medicine, animal spirits was also used in literary culture and referred to states of physical courage, gaiety, and exuberance. In this regard, the literary meaning implied that animal spirits can be high or low depending on the level of health and energy of the individual. It is no wonder then that the modern version of the word in finance relates to investor psychology and confidence in the markets.
While Adam Smith believed that if people pursued their own economic self-interests in a free market economy then there’ll be little to no need for government intervention, John Maynard Keynes understood that people may be irrationally guided in this quest. In his book, The General Theory of Employment, Interest and Money, Keynes explained that trying to estimate the yield of various industries, companies, or activities using general knowledge and available insight into these entities would result in little to nothing. Therefore, the only way people can make decisions in such uncertain environment, is if they are guided by animal spirits.
Animal spirits guide the confidence, fear, and pessimism that impact the decisions that fuel or hamper economic growth. The 2008 financial crisis revived the interest in the role that animal spirits play in the financial markets. If the ‘spirits’ are low, then confidence level will be low which will drive a promising market down even though the fundamentals of the market or economy remain strong. Likewise, if the spirits are high, confidence will be boosted among participants of the economy and market prices will soar. For example, the 2008 market was rife with financial innovation which was initially assumed to be a positive outcome until the financial instruments were riddled with tales of deception and fraud. At this point investor confidence dropped, a sell-off ensued, and the markets plunged.
According to the theory behind animal spirits, business leaders make investment and business decisions on intuition and the behavior of other businesses, rather than analysis. Intuition in behavioral economics, follows the laws of social psychology which is prevalent in the capital market.
After President Donald Trump won the presidential election in November 2016, the markets went bullish indicating the return of animal spirits. Trump’s plans to cut tax and increase spending fueled consumer and business confidence even though it is not known whether his proposals will come to fruition.
To understand how the economy really works, animal spirits must be considered as it helps to explain why individuals and firms make poor investment decisions.