Animal spirits: Right and wrong
The Indian economy has been slowing down over several years now; the Covid-19 pandemic was just the last (big) straw. An important reason is the falling rate of investment. In this context, there is repeated talk of “reviving animal spirits” which could, in turn, push investment. Is this the right approach?
It is important to distinguish between real investment and financial investment. In the latter case, of course, animal spirits or sentiments (the term more commonly used there) play an important role. What about real investments? It is true that surveys often show a correlation between animal spirits, confidence and real investment. But correlation is not the same as causality.
Suppose that a fall in the growth rate of gross domestic product (GDP), profits and debt capacity leads to a fall in real investment. Further, suppose that such factors also lead to a fall in the so-called animal spirits of the management of firms that may have made real investments. So, there is now obviously a correlation between animal spirits and real investment but clearly there is no causality from one to the other! In fact, both low animal spirits and low real investments are caused by a common set of economic factors. This is, in fact, the kind of situation we have been in India for a while.
It is true that though both low spirits and low real investment may be caused by a common set of economic factors, the low spirits can, in addition, have a separate and independent influence on real investment. This is where one may say that animal spirits do have some role in causing low real investment. However, this is usually a second order effect only. It follows from all this that the role of animal spirits in determining real investment is much exaggerated.
Why the difference between the role of animal spirits in financial investment and in real investment? Ordinary households that are not well aware of the complexities in investments invest in financial markets. These households can make mistakes; they can also, in one way or another, tie up the hands of professional fund managers who may be forced to sell low and buy high at times. This is not the case with real investment — at least not in big firms. Why? First, shares are irredeemable. Second, the corporate democracy for shareholders is ineffective.
The term animal spirits became popular during the Great Depression in the 1930s. Then, the stock market had crashed massively; low animal spirits indeed played a role in the market. However, the main issue that bothered John Maynard Keynes in this context was different. He saw that firms were actually — at their level — quite rational in deciding on very little capital formation, given the very low prices at which existing assets were available in the financial markets. His main point does not appear to be low animal spirits amongst managements in firms as the main cause of low real investment.
It is true that Keynes did some “loud thinking” on the difficulties in deciding on real investments. But the way to deal with the difficulties had, in fact, been shown already by Frank Knight in his 1921 book Risk, Uncertainty and Profit. His main conclusion was that because long-term real investments are difficult, there is an important rationale for profit as a reward; it is not that animal spirits must be an important determinant of real investments.
This is not the place to go into the role of animal spirits in modern theoretical economics except to say that the applications of the ideas are far more in financial markets, currency markets, and banking than in the world of real investments.
Though low animal spirits can prevail and these have, in fact, prevailed earlier in the financial markets, it is interesting that except for some brief periods, the animal spirits in the Indian stock markets have hardly been low over the last several years. Also, though the growth of bank credit has been low for a while, this is related primarily to factors like the prolonged after-effects of the Asset Quality Review, the capital constraint, and the legal, regulatory and institutional environment within which the public sector banks operate. So, it is difficult to make a case for low animal spirits even in the financial sector in India at this stage. When real investment is low, the government often tends to give tax exemptions, other concessions and even pep talks in order to “revive animal spirits”. All this is, by and large, not needed. What is needed is a policy to deal with fundamental factors.1