“The markets are moved by animal spirits, and not by reason.” – John Maynard Keynes
Continuous advancements and increased convenience have pushed millions of people to invest in the financial markets. With everything being digitized, investors are at ease as they get all required information on their phone/computer screens. They’re just a click away from participating in the market. However, financial markets and world economies are no less than a roller coaster, where rapid fluctuations, crashes and then immediate booms have become quite common. One day, we witness a major crash in the financial market and soon the market revives. The increased significance of financial markets in the country’s economy has brought to light the economic theory of John Maynard Keynes, wherein ‘animal spirits’ take center stage.
The term ‘animal spirits’ can be dated back to almost 2500 years ago when Erasistratus used it in the fields of human anatomy and physiology. He claimed the presence of certain spirits in the human body which moved within veins, regulating perception, sensation, control and other sensory moments. Besides the scientific use, the term appeared in literature and was even used by some famous novelists like Jane Austen, Daniel Defoe, Henry Fielding etc. In this context, the term was used to describe emotions like courage, exuberance, vivacity, gaiety, sadness, etc. Since then, the term has evolved, having different meanings in different areas.
From the economics perspective, the term was coined by John Maynard Keynes to explain human actions. Contradicting Adam Smith’s thought that human beings pursue their economic interests rationally, Keynes argued for the presence of ‘animal spirits’ in decision making, which earlier theories failed to recognize. Keynes in his book ‘The General Theory of Employment, Interest and Money’ described how human emotions affect financial decisions, especially during times of financial/economic stress and uncertainty. He argued that when rational calculations and rational decisions seem difficult, animal spirits come into picture, and thereby drive our ultimate decisions.
Animal spirits signify human emotions, such as confidence, optimism, pessimism, fear, etc. which hold great significance when making investment decisions. History has showcased that instead of contributing towards positive returns in the form of profits, such spirits tend to turn tables and affect financial decisions negatively, ultimately hampering the growth process.
The reason behind such a negative effect is quite simple. The decisions of a majority of investors in financial markets are driven by mass psychology and their intuitions. Instead of undertaking an in-depth analysis of a particular stock/company and analyzing the future prospects, investors tend to buy and sell stocks on the basis of ‘conventional valuation’. Such conventional valuation arises from the mass psychology of a large number of ignorant investors, resulting in everyone following the herd and thinking emotionally, consequently, overpowering analytical decision making. In fact, some researchers claim that during times of uncertainty industry/company information ‘amounts to little and sometimes to nothing’ because people only follow their inner spirits and intuitions.
If animal spirits are high, emotions like confidence, hope, optimism prevail in the market, which will ultimately push and move the market towards a bullish phase, even if the market and business fundamentals are not strong enough to complement this rise. On the contrary, if these spirits are low, confidence levels are low, then ultimately it leads to a fall in the market, even if company fundamentals are strong. As a result, these spirits often lead to panic or greed within the market which can give rise to bubbles and crashes.
Financial history provides enough evidence (such as the DotCom Bubble, the Great Recession, COVID-19 crashes, etc.) to prove the irrational behaviour and negative consequences of spirits. The DotCom bubble is amongst the most significant examples of these spirits. The beginning of the bubble saw a rapid rise in technology-related stocks which had ‘dotcom’ in their name. The markets rose exponentially with Nasdaq rising from 1000 to 5000 in the period of just 5 years. Instead of analyzing the company stocks, investors were driven by the term ‘.com’ which increased the valuation of such companies from zero to exponentially high share prices. However, the index soon crashed by 76.81% in October 2022 which highlighted the fact that it was a bubble driven by human emotions.
Shortly after the DotCom bubble, a similar crash was witnessed in 2008-09, named the Great Recession. The recession is now considered to be among the worst economic downturns in history. It saw a massive decline in the US GDP and a rise in unemployment rates. This period also saw the increasing use of innovative financial instruments like CDOs, CDS, especially in the US housing market. The initial trend was quite positive as low mortgage rates and cheap credit facilities attracted people. Even the ones with poor credit history (subprime borrowers) got the opportunity to buy a home. However, a saturation point was reached, thereby creating a massive decline in housing prices. Investor confidence and optimism, which was at an all time high, plunged massively with markets witnessing a major crash. This became a clear instance of animal spirits taking over our decisions.
The idea behind ‘animal spirits’ is under constant development wherein some economists and researchers support it while others don’t. Similar research was undertaken by famous economists, George A. Akerlof and Robert J. Shille, who added a new dimension to the concept of animal spirits. They identified four social psychological factors and termed them under ‘animal spirits’. These factors include confidence, corruption, money illusion, fairness and stories.
Confidence is the key influencer on economic behaviour and decision making. There have been instances (like the great recession) wherein decision making had no reliable basis and rationality grounds, but confidence took the stage.
Corruption comes into the picture when there is a random hype over a certain industry or stock. Overenthusiastic people predict profits amidst such a hype without actually analyzing the fundamentals and growth prospects. Unaware of the good and bad, many make such people their bait and misinform them. A similar occurrence happened with subprime mortgages in 2008 wherein corruption was the key influence. The third factor of money illusion implies failure to understand the inflation and deflation in prices. Wage rates are a perfect example of money illusion, as a result, age contracts are not indexed according to the overall economic variability. Stories are also a key influence. Here, the story that seems most believable ‘wins’ without even making the slightest effort to analyse it. Each economic bubble till date has a story of quasi-infinite growth and false hopes associated with it.
Over the years we have observed a standard pattern, wherein we are not able to identify warning signals until a disaster happens in the form of a collapse, rising unemployment levels, etc.
Why don’t we recognize these warning signals, animal spirits and initiate quick action to prevent the disaster?
The reason behind this is because everyone has always been taught about benefits and just benefits. Textbooks never spoke about warning signals and ways to deal with them. The only examples being given are those of rational humans, who are not realistically accurate. There is a need to devise a regulatory system involving supervision and regulations which accounts for animal spirits and thus move towards informing people and protecting them from being fooled. As observed, animal spirits play a significant role in destabilizing economies, thereby involvement of the government becomes important. Without such intervention employment levels will fluctuate significantly, financial markets will again witness bubbles, creating chaos and ruckus everywhere.
By Aarushi Doomra