John Maynard Keynes introduced the psychological concept of “animal spirits” in finance in the 20th century.
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What Are Animal Spirits? Who Coined the Term?
Economists look at an individual’s behavior to understand stock market movements because emotion often drives market sentiment. The term “animal spirits” was first used by a Greek physician named Galen in the second century CE. Galen believed an entire system of spirits were running through the human body: Natural spirits came from the lungs, vital spirits were found in the blood, and animal spirits, which came from the brain, were embodied as movements and actions.
The 20th century author, educator, and iconoclast John Maynard Keynes connected animal spirits with finance in his seminal book, The General Theory of Employment, Interest and Money. Keynes’ central belief, that economic activity was dictated by demand and not supply (as previously thought), forever changed the field of economics. In this book, Keynes also described how consumer confidence levels (i.e., animal spirits) could actually influence the markets.
What Is an Explanation of Animal Spirits in Finance?
Keynes believed that people often rely on instincts or emotions to inform their decisions. The underlying reason has to do with the fact that our behavior is based on a long-term outlook. While a person can’t ever fully know what the future will be, Keynes said, they also can’t be paralyzed by fear of the unknown. Therefore, humans must take action in order to survive. Keynes referred to this feeling as the animal spirits, or a “spontaneous urge to action rather than inaction,” which so often is based on nothing more than a hunch or gut feeling.
Acting based upon one’s emotions obviously distorts one’s ability to think rationally; in the stock market, when investors make these rash decisions, they often aren’t acting alone. So many times, when investors take action, they are acting collectively, in a sort of herd mentality, ignoring fundamentals in favor of their emotions. Therefore, their behavior, or the sum of their market movements, can lead to speculation, which is rampant, emotion-based selling (in particular) that is often based more on rumor instead of facts.
One investor acting impulsively might not make a trend, but when you multiply these actions millions of times, representing the actions of just as many irrational investors, you can see how animal spirits can actually cause asset bubbles to form, markets to grow overvalued, or worse, capitulation to occur—animal spirits are even to blame for many recessions.
What Are Some Examples of Animal Spirits?
Animal spirits played a part in two of the most recent stock market crashes:
The Financial Crisis of 2007–2008
Inflated home prices and rising interest rates were a combustible mix in 2008. Demand for new homes had caused prices to rise more than 100 percent in under a decade. The economy remained hot until the Federal Reserve began to raise interest rates—and in so doing, they unleashed a wave of defaults among U.S. subprime mortgage borrowers, whose adjustable monthly rates skyrocketed as a result.
The carnage swept globally since investment banks had been trading collateralized mortgage obligations for profits. When Lehman Brothers declared bankruptcy, on September 15, 2008, panicked investors pulled $196 billion from money market accounts, and both the S&P 500 and the Dow Jones Industrial Average would crash in the following days. In total, the Dow would lose 50% of its value by March, 2009.
The Collapse of the Dot-Com Bubble
The late ‘90s were a time of “irrational exuberance,” then-Fed Chairman Alan Greenspan noted, with asset prices in the technology sector growing to bubble proportions—often with little proof on a company’s balance sheet.
Rising interest rates and a recession in Japan fueled the bubble’s spectacular burst in March, 2000, causing investors to dump their tech shares and sending the Nasdaq into a tailspin. It would bottom in October 2002, erasing nearly 40% of its value.
Is There a Cure for Animal Spirits? Was Keynes Right?
Interestingly, Keynes said more accountable governments could resolve a lot of the problems that individual behavior created. In particular, he believed that recessions—and in his case, the Great Depression—would end if a government undertook massive stimulus programs that would fund projects and thus spur employment.
He also believed that a monetary authority such as a central bank should reduce interest rates during times of financial crisis in order to foster an easier and more trustworthy environment for banks to make loans. What would result from such government stimulation? Simply put, there would be more demand for goods and services, which would positively affect the economy; production would increase, and eventually, unemployment would fall.
U.S. President Franklin Delano Roosevelt took Keynes’ advice to heart— Roosevelt unveiled a large-scale public infrastructure program known as the New Deal in 1934. It would create jobs for millions of people and eventually help to end the Great Depression.
Ben Bernanke, the 14th Chairman of the U.S. Federal Reserve, also applied Keynesian theories to resolve the 2007–2008 Financial Crisis. Bernanke slashed interest rates to zero for an unprecedented seven years as a way to alleviate the economic stagnation that resulted from the global ramifications of toxic subprime debt. In fact, U.S. President Obama credited Bernanke for helping avert a second Great Depression.