What is 'Animal Spirits'?

Animal Spirits is a term used by the famous British economist, John Maynard Keynes, to explain financial and buying decisions in conditions of uncertainty. In Keynes’ 1936 publication, The General Theory of Employment, Interest and Money, animal spirits describes the human emotion that drives consumer confidence. In modern economic terms, animal spirits describes the psychological factors that drive investors to take action when faced with high volatility in the capital markets. The term is derived from the Latin spiritus animalis which means the breath that awakens the human mind.

BREAKING DOWN 'Animal Spirits'

The technical concept of animal spirits, or spiritus animalis, can be traced as far back as 300 BC when the term was used in the fields of human anatomy and medicine physiology. The term referred to the fluid or spirit present in sensory activities and nerves in the brain. Animal spirits was also used in literary culture and referred to states of physical courage, gaiety and exuberance. The literary meaning implies that animal spirits can be high or low depending on the level of health and energy of the individual. The modern version of the term is used in finance to describe investor psychology and confidence.

Adam Smith, another famous British economist, believed that if people pursued their own economic self-interests in a free market economy, there would be no need for government intervention, John Maynard Keynes understood that people might be irrationally guided in pursuing their economic self-interests. 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 would realize little to nothing. Therefore, the only way people can make decisions in such an uncertain environment is if they are guided by animal spirits.

The Role of Animal Spirits in Financial Markets

Animal spirits represent the confidence, fear and pessimism that impact the decisions that fuel or hamper economic growth. The 2008 financial crisis revived interest in the role that animal spirits play in the financial markets. If spirits are low, then confidence levels will be low, which will drive a promising market down even though the fundamentals of the market or economy remain strong. Likewise, if spirits are high, confidence will be high among participants in the economy and market prices will soar. For example, the 2008 market was rife with financial innovation, which was initially assumed to a positive outcome until the financial instruments were found to be deceptive and fraudulent. At this point, investor confidence plummeted, a sell-off ensued, and the markets plunged.

According to the theory behind animal spirits, the decisions of business leaders are based on intuition and the behavior of competitors rather than analysis. Intuition in behavioral economics follows the laws of social psychology, which affect the capital markets.

After President Donald Trump won the presidential election in November 2016, the markets were bullish indicating a return of animal spirits. Trump’s plans to cut tax and increase spending fueled consumer and business confidence although there was no way to be sure that the proposals would come to fruition. Animal spirits is a component of economics and one that helps to explain why individuals and firms sometimes make poor investment decisions.

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