Animal Spirits

by Jerry O’Driscoll

In a previous post, Mario Rizzo reminds us that Keynes was concerned with the volatility of investment.  Keynes was not alone.  By the dawn of the 20^th century, virtually every significant business cycle theorist viewed the volatility of investment as the central theoretical problem.

In the General Theory, Keynes (p. 149) posed the problem as follows: “The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.” It quickly becomes clear that Keynes means “expectations,” not knowledge.  And investment is not governed by “the genuine expectations of the professional entrepreneur” (p.151).

Long-term valuations become “a game of Snap, of Old Maid, of Musical Chairs” (pp. 155-56).  He then presents what has become known as the Keynesian beauty contest in which investors must guess what other investors will guess.   It is average opinion guessing what average opinion will guess about average opinion to “the fourth, fifth and higher degrees” (p. 156).   For Keynes, how do we break out of these straitjackets?  It is through bouts of “spontaneous optimism” or “animal spirits” (p.161).

Keynes was predisposed to offer psychological explanations for economic behavior.  In Two Philosophies of Money: The Conflict of Trust and Authority, S. Herbert Frankel took note of that propensity. “Keynes was fond of referring to psychological factors but as various writers have pointed out, in particular Professor Gunter Schmolders, his psychology was of the crudest.  It consisted largely in setting up abstract puppets or models of his own very unsophisticated beliefs concerning the motives which cause individuals to act in a certain manner” (p. 127,n27).

Keynes offered little more than pop psychology to buttress his policy prescriptions.  Yet current policy is predicated on animating animal spirits. Keynes had an explanation for how that could come to be: “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back” (p. 383).