Animal spirits

3 key takeaways

• Animal spirits refer to the emotions and instincts that drive economic decision-making.
• They can significantly impact financial markets, investment decisions, and economic cycles.
• The term highlights the role of psychological factors in economic behavior, beyond purely rational considerations.

What are animal spirits?

The term “animal spirits” was popularized by the economist John Maynard Keynes in his 1936 book “The General Theory of Employment, Interest, and Money.” Keynes used it to describe the emotions, instincts, and psychological factors that influence human behavior, particularly in the context of economic decision-making. Animal spirits encompass feelings of confidence, fear, optimism, and pessimism that drive the actions of consumers, investors, and business leaders.

Importance of animal spirits

Animal spirits are important because they play a crucial role in shaping economic outcomes. While traditional economic models often assume that individuals act rationally, animal spirits acknowledge that emotions and psychological factors can lead to irrational behavior. Understanding animal spirits helps explain why markets can be volatile, why economic booms and busts occur, and why people sometimes make decisions that seem inconsistent with purely rational calculations.

How animal spirits work

Impact on markets: Animal spirits can cause financial markets to experience periods of excessive optimism (bubbles) or pessimism (crashes). For example, during a market bubble, investors may become overly confident and drive asset prices to unsustainable levels. Conversely, during a crash, fear and panic can lead to widespread selling and plummeting prices.

Investment decisions: Business leaders and investors are influenced by their perceptions of the economic environment. High levels of confidence can lead to increased investment and risk-taking, while fear and uncertainty can result in reduced spending and risk aversion.

Consumer behavior: Consumer confidence affects spending patterns. When consumers feel optimistic about their financial future, they are more likely to spend money, boosting economic activity. In contrast, when consumers are worried about the economy, they may cut back on spending, leading to slower growth.

Examples of animal spirits

• Dot-com bubble: In the late 1990s, excessive optimism about the potential of internet companies led to a stock market bubble. Investors poured money into tech stocks, driving prices to unsustainable levels. When the bubble burst, it resulted in significant market losses and economic disruption.
• 2008 financial crisis: The financial crisis was partly driven by excessive risk-taking and a sense of invincibility among financial institutions. When confidence evaporated, it led to a severe economic downturn as panic and fear spread through the markets.
• Post-recession recovery: During economic recoveries, improving consumer and business confidence can lead to increased spending and investment, helping to drive economic growth.

Real-world application

Consider a scenario where a new technology is introduced, generating significant excitement and optimism among investors. This optimism drives up the stock prices of companies involved in the technology, creating a market bubble. As the reality of the technology’s limitations sets in, investor sentiment shifts to fear and pessimism, leading to a sharp decline in stock prices and market instability. This cycle of boom and bust can be explained by the influence of animal spirits on investor behavior.

Understanding animal spirits is essential for economists, policymakers, and financial professionals as it provides insights into the psychological factors that drive economic behavior. Recognizing the impact of emotions and instincts can help in designing policies and strategies to manage economic cycles and market volatility.

Related topics you might want to learn about include behavioral economics, market psychology, and Keynesian economics. These areas provide further insights into the role of human behavior in economic decision-making and market dynamics.