What are “animal spirits”?
– Definition: “Animal spirits” is a phrase (coined by John Maynard Keynes) that refers to the psychological and emotional forces—confidence, fear, optimism, pessimism—that influence economic and financial decisions when people face uncertainty. These feelings can push prices, hiring, investment, and consumption away from what purely technical or fundamental analysis would predict.
Origins and a short history
– The phrase traces back to the Latin spiritus animalis (literally “the breath that animates the mind”) and had older uses in anatomy and literature to describe energy or courage.
– Keynes revived the idea in The General Theory to explain why business leaders and investors often act on intuition or sentiment rather than strict calculation under uncertainty.
– The concept re-entered mainstream discussion after George A. Akerlof and Robert J. Shiller published their book arguing that psychology matters for macroeconomics
. They used examples and evidence to show that moods and narratives can change aggregate demand, wages, and saving behavior in ways that standard rational-agent models do not fully capture.
How animal spirits work (mechanisms)
– Confidence and expectations: When households and firms feel confident about the future, they are more likely to spend and invest. The reverse holds when fear dominates. Expectation here means a subjective forecast about future income, prices, or profitability.
– Herding and social proof: People copy others when information is scarce. In markets this produces momentum and bubbles; in the real economy it can amplify hiring or layoffs.
– Loss aversion and risk perception: Psychological biases (for example, loss aversion—the tendency to prefer avoiding losses rather than acquiring equivalent gains) change the effective cost of taking economic decisions.
– Narrative effects: Simple stories (about innovation, crises, policy) shape beliefs and thus actions. Narratives can spread rapidly and alter aggregate behavior.
– Feedback loops and self-fulfilling moves: Rising investment can raise profits and justify optimism; falling demand can validate pessimism. These loops can push outcomes away from what purely mechanistic models predict.
Empirical indicators (how economists and market participants measure sentiment)
– Consumer confidence indexes: Conference Board Consumer Confidence; University of Michigan Consumer Sentiment. These are survey-based measures of household expectations and plans.
– Business sentiment surveys: Purchasing Managers’ Index (PMI), business outlook surveys.
– Market-based measures: VIX (implied volatility index) as a gauge of investor fear; credit spreads as a gauge of stress.
– Text and big-data measures: News sentiment scores, social-media indicators, and Google Trends are increasingly used to track narratives in near real time.
Each indicator has pros and cons: surveys are direct but slow and subject to framing; market measures are timely but reflect only participants in financial markets.
Worked numeric example (simple macro effect)
Assumptions:
– Aggregate current consumption = $5,000 billion.
– A positive shift in confidence raises planned consumption by 1% immediately.
– Fiscal/aggregate multiplier (captures indirect effects) = 1.5.
Step 1 — direct increase in consumption:
Increase = 1% × $5,000bn = $50bn.
Step 2 — total effect on GDP (including multiplier):
Total GDP impact ≈ $50bn × 1.5 = $75bn.
Interpretation: A modest 1% rise in consumption driven by improved confidence could—under these assumptions—raise aggregate demand by roughly $75bn. Assumptions matter: different base consumption, a different multiplier, or offsetting policy/behavioral responses would change the result.
Practical checklist for traders and students (how to use sentiment thoughtfully)
1. Define your horizon: sentiment matters more for short-to-medium horizons; fundamentals dominate long-term value.
2. Choose indicators relevant to your thesis (e.g., consumer confidence for retail demand; PMI for industrial activity).
3. Normalize and time-align data before comparing (monthly vs. daily series).
4. Check lead/lag relationships historically—do sentiment shifts lead the variable you care about?
5. Use sentiment as a filter or confirmation tool, not the sole trigger for positions.
6. Backtest any rule that uses sentiment and include transaction costs and slippage.
7. Maintain risk controls—sentiment signals can reverse quickly.
8. Consider macro and policy context (monetary/fiscal actions can override sentiment effects).
Limitations and criticisms
– Measurement error: Sentiment is noisy and sensitive to question framing and sampling.
– Endogeneity: Sentiment both influences and is influenced by economic outcomes; causality can be hard to establish.
– Cultural and institutional differences: The same sentiment reading can mean different things across countries or market structures.
– Model risk: Incorporating animal spirits into formal models requires assumptions about how emotion translates into choices; those assumptions can be contested.
Takeaway (practical summary)
Animal spirits explain why psychology and narratives matter for economic fluctuations and asset-price moves. For practitioners, sentiment indicators are useful as context and confirmation but should be combined with fundamental analysis, robust testing, and risk management. Always be explicit about your assumptions when you translate a change in sentiment into an expected economic or market effect.
Further reading
– Investopedia — “Animal Spirits”: https://www.investopedia.com/terms/a/animal-spirits.asp
– Akerlof, George A., and Robert J. Shiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (Princeton University Press): https://press.princeton.edu/books/hardcover/9780691152183
– Conference Board — Consumer Confidence Data: https://conference-board.org/data/consumerconfidence.cfm
– University of Michigan — Surveys of Consumers (Consumer Sentiment): https://data.sca.isr.umich.edu/
– CBOE — VIX FAQ (implied volatility as a fear measure): https://www.cboe.com/tradable_products/vix/faq/
Educational disclaimer
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Educational disclaimer This content is provided for educational and informational purposes only and does not constitute investment, tax, legal, or other professional advice. It is not a recommendation or an offer to buy or sell any security or financial instrument. You should not rely solely on this material to make investment decisions. Always perform your own due diligence, be explicit about assumptions, test any strategy on historical and out-of-sample data where possible, and consult a licensed professional who can take into account your personal circumstances.
Limitations and uncertainty: Models, sentiment indicators, and historical relationships described here rely on assumptions and are subject to measurement error, model risk, and changing market structure. Past performance is not indicative of future results. Use sentiment indicators as one input among many, apply risk-management controls (position sizing, stop-losses, diversification), and be prepared for outcomes outside the model’s expectations.
Selected reputable sources for further reference
– Federal Reserve Board — official site and research: https://www.federalreserve.gov/
– International Monetary Fund (IMF) — research and global outlooks: https://www.imf.org/
– Organisation for Economic Co-operation and Development (OECD) — economic data and analysis: https://www.oecd.org/
– National Bureau of Economic Research (NBER) — working papers on behavioral macroeconomics and finance: https://www.nber.org/