Animal Spirits and Their Effects

Animal Spirits dissects standard economic theories and demonstrates their failure to account for human emotions, even though emotions have a large impact on the economy. Traditional economic theory operates under the assumption that individuals act rationally and make economic decisions based on purely economic reasons.

These economic theories are widely accepted by professional economists and are utilized in governmental policy-making. Unfortunately, traditional economic theory does not examine how the economy behaves when individuals make rational decisions based on non-economic reasons, irrational decisions based on non-economic reasons, or irrational decisions based on economic reasons.

In the quest to make economics a more scientific and calculable study, economists have largely left out the single largest influence on the economy: the animal spirits of human emotion. All animal spirits fall into one of five different categories: confidence, fairness, corruption, money illusion, and storytelling.

All of these categories have strong effects on the current economy, and their influence must be taken into account when creating government policy and making economic predictions. Ignoring the fact that human emotions affect purchasing and financial decisions only serves to create policy that will not hold up to these constantly-changing animal spirits.

By accepting and understanding these emotions, however, economists and policy makers can create more effective policies and plans. These policies and plans will not be permanent, however, and should change according to the cultural, economic, and emotional climates of the time.

For example, when banks stopped becoming mortgage holders and just became mortgage initiators, policy did not keep up with this change. Traditionally, banks would approve individuals for mortgages and then hold the mortgages themselves.

Because they held the mortgages, it prevented them from writing mortgages that people could not afford because they did not want to end up with the property or losing out on mortgage payments. Then, in the 2000s, banks began to sell the mortgages they had to other financial institutions.

These financial institutions did not know about the fiscal standing of the mortgages they held because the banks had divided individual mortgages into parts and sold the different parts to different institutions. Because of the large signing fees the banks earned when they approved individuals for mortgages, and the fact that they planned on selling the mortgages after they were signed, the banks approved people who could not actually afford them.

Because policy did not take this into account, the real estate bubble grew and eventually crashed once the individuals who received mortgages they could not afford began to have their homes foreclosed upon. This is just one example of the many ways in which animal spirits can affect the economy.

This article is based on the book "Animal Spirits." The book summary is available online at Business Book Summaries.