The Remnants of Feelings in Mainstream Economics: Animal Spirits

From the dawn of economic thinking, economists were fascinated by emotions and their role in the economy. The father of economics, Adam Smith, was also fascinated by it. In his idea, the invisible hand – which is perhaps the most misused and misunderstood metaphor in economic thinking – originally applied to distribution problems, where societies did not wish to unjustly distribute the goods and profits in the market. The presence of an invisible hand lead the people to act according to the benefits of society. Numerous economist thinkers were interested in moral and distributive questions, let that be Smith, Mill, Hayek, or Thornton.

However, during the marginalist and neoclassical revolutions, when economists were busy trying to create mathematical models for decision-making processes, emotional factors were omitted. This was due to them being too erratic and way too complicated to include in such models (yet, they still believed that emotions have powerful effects on the economy). Nonethless, a number of economists continued to contribute to the literature of the effects of emotions on the economy: Edgeworth, Scitovsky, Katona, Simon – just to name a few. But perhaps the most widely accepted view came from one of the most influential figures in economic thought – Keynes.

A Brief Story on Animal Spirits

In macroeconomics, there’s a theory for business cycles, which aims to understand why the booms and busts happen in an economy. One of the first written business cycles – as Thomas Sedlacek observed – is documented in the Bible, when Joseph deciphered the dream of the Pharaoh:

(Genesis 41:29-30) Behold, seven years of great abundance are coming throughout the land of Egypt, but seven years of famine will follow them. Then all the abundance in the land of Egypt will be forgotten and the famine will devastate the land. (Genesis 41:34) Let Pharaoh take action and appoint commissioners over the land to take a fifth of the harvest of Egypt during the seven years of abundance.

Thus, the economy is a constant circle of “abundance” and “famine”, booms and busts. First, economists considered these business cycles to be completely exogenous: external shocks that affect an economy. According to this view, fluctuations in an economy can only be attributed to random changes in external variables.

Later, economists began to analyze if these fluctuations can occur even when macroeconomic fundamentals are relatively stable overtime. The first explanation says that in this case, distortions occur when endogenous factors in an economy fail to reach and remain at a stationary state while the fundamentals are intact (For more information, see Hicks (1950) on full-employment equilibrium).

The second view can be traced back to John Maynard Keynes. He argued that our decisions “(…) depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic…” (Keynes ,1936, pp. 161-162.) Keynes called this phenomenon Animal Spirits, however, he never exactly specified or elaborated on what he meant by it (in this sense, Keynes was like Einstein: they both had marvelous ideas, thus giving ‘homework’ for economists and mathematicians alike for the next century to come). Generally, Animal Spirits tend to be understood as the ‘mood of the market’, whether the perceived prospects tend to be positive or negative.

From a macroeconomic point of view, economists try to use the theory of Animal Spirits by applying it to the labor market: when spirits are high, employment will rise, and with greater labor force, an increase in output with follow, validating the original perception of the economic prospects, thus creating a self-fulfilling prophecy. What can be a nuisance, however, is that with the increase of the labor market competitiveness, companies will have to compete for the workers, thus increasing the hiring costs (but this factor is usually simplified or completely neglected). Similarly, in the case of low spirits, the demand for labor will decrease, and consequently, the output is expected to decrease as well.

Another area of macroeconomics where Animal Spirits is present is in the consumption functions, namely the measurement of ‘consumer confidence’. For example, for the 1990-1991 recession, Blanchard (1993) blamed mainly the nature of the business cycles, but also the loss of optimism among the consumers, deriving from the negative experience coming from the recession itself. This will suffice to go back to the recent crisis of 2008, where in the coming years, confidence (and trust) in banks severely declined, and this can be observed even today.

Economist argue that these heuristic expectations can, in fact, be rational. Howitt and McAfee (1992) argue that “people may rationally anticipate the waves of optimism and pessimism that keep employment fluctuating forever” (pp. 498). One would argue that this is not the case. Remember the Monte Carlo fallacy? In the case of a roulette-game, after 49 consecutive plays where the winner was red, we tend to think that the 50th round will surely be black. Why? Because we tend to give probabilistic balance a great role when dealing with uncertainty. Rationally, the 50th round would still be a 50% chance of being black as opposed to red (supposing that the roulette-table is in fact not rigged).

Turning to a more micro-centered approach, Loewenstein and O’Donoghue (2004) applied Animal Spirits in a different way. In their view, people have “dual minds”, two parallel systems in decision-making based on psychological and neuro-scientific research. They call the first one the “deliberative system”, which in essence is along the lines of standard rational economic thinking. The second one is called “affective system”, which accounts for the emotional thinking (or rather the emotional reactions).

This two-sided decision-making system has several important implications. First, they note that external stimuli can have great effects on activating the affective system. Another interesting factor is individuals’ intrinsic (or endogenous) willpower, which accounts for the deliberative system’s oppression over the affective system. In other words: how effective can one’s rationality be in repressing their own gut feelings. This hypothesis also carries in itself the motion of cognitive dissonance, for when a decision is made based on emotions or gut feelings, often times we long for choosing the rational way, and vice versa. Finally, the model manages to explain how in seemingly indifferent situations people often manage to make extremely different actions.

Homo Erraticus rather than Homo Oeconomicus?

With the ever-growing dissatisfaction of complete rationality in economic models, alternatives like behavioral economics are in their Renaissance. Some economists turned to Sociology, Psychology, Neural Sciences and several other fields to resolve the problem of emotions in economics. New theories, such as bounded rationality and reference point-based decision-models, try to explain the effects emotions bring to the table. The purpose of this article was not to critique behavioral-macroeconomics methods; its goal was to address that maybe we should dig even deeper, back to the fundamentals of macroeconomics. Creating a new consumption function, or adding a couple more parameters might not do the trick, as we may have to go back to the micro level. Whether you agree with this or not, one thing is for certain: we still need to do our homework that Keynes and a number of other great economic thinkers left for us.