There has been much talk of late about animal spirits, a term first used by British economist John Maynard Keynes, as a motivator of financial behavior.  It could be a key to both the depth of this recession—that some are already calling the “Great Recession”—and its duration.  This is because the underlying credit crisis has been characterized as a crisis in confidence.

Banks are afraid to lend, in other words, because they fear that borrowers won’t be able to repay their loans, or that the mortgages or mortgage backed securities already on their books won’t be repaid.  This is while consumer spending, which fuels 70 percent of economic activity these days, is lower either because consumers make less money and no longer can borrow as much, and/or are afraid of losing their job and so save more.

And that is the best definition of animal spirits, the basis of so-called Keynesian economics, although Robert Shiller and George Akerlof are refining its definition in their latest book, Animal Spirits.  In essence, they attempt to answer the question; what causes aggregate demand, or the overall demand generated by consumers and businesses for goods and services, to shrink or expand?

Their answer is consumers are not necessarily motivated by rational considerations.  We can see that the housing bubble was caused by home buyers who didn’t want to look at the fact that housing prices might decline, or interest rates might rise to unpleasant levels.  And we know that stock investors can become irrationally exuberant.

Obviously, something had to start this downturn in confidence.  Some say it was the growing inequality of incomes that required middle and lower income consumers to borrow beyond their means if they wanted to maintain their standard of living.  Many economists maintain it was the worldwide glut of savings that drove down interest rates to record lows that spurred such borrowing.

But regardless of the cause, excess borrowing drove up home prices to unsustainable levels.  When the housing bubble burst, it caused a diminution of the ‘wealth effect’, which meant consumers and banks felt less wealthy and so cut back on their spending and lending.  This in turn caused producers to cut production and jobs, which exacerbated the downward economic spiral.

So the cure has to include simulating aggregate demand, which means finding a way to put more money into those who buy the most products and services, mainly consumers.  But confidence is more than giving consumers rebate checks, or tax cuts to investors, since those policies have not given us much bang for the bucks in the past.

In fact, the theory of Animal Spirits highlights a profound return to New Deal economics, which means using government as the lender and spender of last resort to kick start the private economy.  Government at present is the only entity with the means to do so.  Only then will businesses want to expand and begin investing in new plants, equipment, and jobs.

Harlan Green © 2009