What is Animal Spirits?
Animal Spirits is a term used by the famous British economist, John Maynard Keynes, to describe how people arrive at financial decisions, including buying and selling securities, in times of economic stress or uncertainty. In Keynes’ 1936 publication, The General Theory of Employment, Interest and Money, he speaks of animal spirits in terms of the human emotions that affect consumer confidence. In modern terms, animal spirits describes the psychological and emotional factors that drive investors to take action when faced with high levels of volatility in the capital markets. The term is derived from the Latin spiritus animalis, which means "the breath that awakens the human mind."
Animal Spirits in Ancient Medicine and Literature
The technical concept of spiritus animalis can be traced as far back as 300 B.C. when the term was used in the fields of human anatomy and medical physiology. There, animal spirits referred to the fluid or spirit present in sensory activities and nerve endings in the brain. Animal spirits also appeared in literary culture, where it referred to states of physical courage, gaiety and exuberance. The literary meaning implies that animal spirits can be high or low depending on an individual's degree of health and energy.
Animal Spirits in Finance and Economics
Today, the term animal spirits is used in finance to describe market psychology and behavioral economics. Animal spirits represents the emotions of confidence, hope, fear and pessimism that can affect financial decision making, which in turn can fuel or hamper economic growth. If spirits are low, then confidence levels will be low, which will drive down a promising market — even if fundamentals of the market or economy may remain strong. Likewise, if spirits are high, confidence among participants in the economy will be high, and market prices will soar.
According to the theory behind animal spirits, the decisions of business leaders are based on intuition and the behavior of their competitors rather than on solid analysis. Keynes understood that in times of economic upheaval, people might be irrationally guided when pursuing their financial self-interests. Keynes further posited in The General Theory that trying to estimate the future yield of various industries, companies or activities using general knowledge and available insight "amounts to little and sometimes to nothing." He proposed that the only way people can make decisions in an uncertain environment is if they are guided by animal spirits.
Animal Spirits and the Great Recession
In 2009, the term animal spirits returned to popularity when two economists — George A. Akerlof (Nobel laureate and professor of economics at University of California) and Robert J. Shiller (professor of economics at Yale University) — published their book, Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism. Here, the authors argue that although animal spirits are important, it is equally important that the government actively intervene to control them — via economic policymaking — when necessary. If the spirits are left to their own devices, the authors postulate, then capitalism could get out of hand, and result in the kind of overindulgence that we saw in the 2008 financial crisis.
For example, from the late-1990s through the 2000s, and peaking around 2008 in The Great Recession, the markets were rife with financial innovations. Creative use of both new and existing financial products — like collateralized debt obligations (CDOs) — abounded, particularly in the housing market. Initially, this trend was thought to be positive, that is until the new financial instruments were found to be deceptive and fraudulent. At this point, investor confidence plummeted, a sell-off ensued and the markets plunged. A clear case of animal spirits run amuck.
Real World Example — Aftermath of 2016 Presidential Election
On November 9, 2016, the day after President Donald Trump won the U.S. presidential election, financial markets experienced a massive sell-off in early morning trading. There was a great deal of uncertainty about the new president, and Trump himself was not always clear and consistent about his policies. Then on the same day, the initial negative reaction dramatically swung into reversal, as across the board, the market closed with huge gains.
Trump’s bold campaign promises to cut taxes and increase spending fueled consumer and business confidence — despite the fact that there was no way to be sure at the time that Trump's proposals would come to fruition. This bullishness, stoked by the sentiments of hope and optimism, might well be the animal spirits roaring to life.