Animal Spirits

Published Apr 5, 2024

Definition of Animal Spirits

The term “animal spirits” refers to the emotional and psychological aspects of human behavior that influence confidence and decision-making in economies. Originally coined by John Maynard Keynes, a famous economist, in his 1936 book “The General Theory of Employment, Interest, and Money,” animal spirits describe the instinctive, gut feelings that drive entrepreneurs to take risks and consumers to spend money, even in the absence of solid, rational grounds. It’s this force that can drive economic cycles and market trends, independent of fundamental factors.

Example

Consider the stock market. When investors are optimistic, buoyed by what Keynes referred to as their “animal spirits,” they are more likely to invest in stocks, driving up market prices, even if the underlying economic indicators do not fully justify such optimism. Conversely, if investors’ animal spirits are low, perhaps due to a recent financial scare or geopolitical instability, they might withdraw from the market or flock to safer investments, causing stock prices to fall, regardless of the companies’ fundamentals.

This dynamic is not limited to the stock market. Animal spirits can influence various economic activities, such as consumer spending, business investment, and housing markets. For instance, a surge in consumer confidence can lead to increased spending, driving economic growth, even if individual financial situations haven’t improved substantially.

Why Animal Spirits Matter

Understanding the role of animal spirits is crucial for economists, policymakers, and investors because it helps explain why markets and economies might boom or bust beyond what fundamental indicators would suggest. Recognizing the impact of human emotions and psychological factors on economic decisions can lead to better forecasts and policies that either harness these spirits for growth or mitigate their negative effects during downturns.

Furthermore, animal spirits highlight the importance of confidence and sentiment in the economy, underscoring the fact that economics is not solely driven by numbers and rational decision-making but also by human emotions and perceptions.

Frequently Asked Questions (FAQ)

How do policymakers influence animal spirits?

Policymakers can influence animal spirits through monetary and fiscal policies that affect economic confidence. For example, cutting interest rates or increasing government spending can boost confidence, encouraging spending and investment. Conversely, raising interest rates or cutting back on government spending can dampen economic activity if it negatively impacts confidence.

Can animal spirits lead to economic bubbles?

Yes, animal spirits can lead to economic bubbles. When optimism and confidence among investors and consumers become detached from economic fundamentals, prices of assets like stocks, real estate, or commodities can rise to unsustainable levels, creating a bubble. Once market participants recognize the disparity, confidence can plummet, leading to a sharp correction or a burst of the bubble.

Are animal spirits always beneficial for the economy?

While animal spirits can drive innovation, investment, and economic growth, they can also lead to irrational market behaviors, speculative bubbles, and subsequent crashes. Therefore, while they can be beneficial, they also represent a source of volatility and risk in the economy.

In conclusion, the concept of animal spirits offers a lens through which to view the often-irrational nature of human economic behavior. By accounting for psychological factors, economists and policymakers can gain a fuller understanding of economic fluctuations and the ways in which confidence and emotions impact markets and the broader economy.