Animal Spirits Driving Economic Change

economic actors to the brink of the abyss, but economic theory could not integrate these phenomena. George Akerlof and Robert Shiller blame animal spirits as the source of macroeconomic excesses, pushing the term towards a negative perception. This is in contrast to the fathers of animal spirits, Keynes and Schumpeter, who described them as creative and entrepreneurial drives.

Dr. Nicolaus Berlin provides evidence that economic theory, which is based on profit maximization, is obsolete. Economic change cannot be explained by profit motives alone; animal spirits are indispensable in this equation. It needs at least seven more motives to spur and drive innovation: The drive for independence, the drive to hunt, the drive to emulate, the drive to compete, the drive to bond, the drive to explore and the drive to create. The captivating chapters of this book open the readers' mind for these subliminal forces.

Human nature can now be integrated in economics, as a set of non-rational programs that evolved to aid adaptation to new circumstances and environments. Dr. Berlin explores this revolutionary approach of animal spirits and provides a fundamentally new view of economic motivation. This is a defining moment in behavioral economics.

Univ. Prof. Dr. Linda Pelzmann,

Head of Behavioral Economics, Alpen-Adria University Klagenfurt/Vienna, -Research Professor and Visiting Scholar at Harvard University, Cambridge, USA

Klagenfurt, July 2014

Preface

Economy and society are going through The Great Transformation21 as I have named the process of profound changes when I first published its driving forces, patterns and dynamics back in 1997 in my book on Corporate Governance. When diminished expectations and frustration spread, when the economy stagnates and shrinks, when prices appear to find no bottom, when profits are out of reach and the mood is deeply depressed, what still drives entrepreneurs and industry leaders?

As we have learned from the Great Depression in the early 1930s it's the Animal Spirits - and the accompanying social moods - which create a spontaneous urge for action rather than inaction. When Animal Spirits are depressed and spontaneous optimism falters, leaving us to depend on nothing but rational reason, enterprise will fade and die.

Money alone cannot stimulate the economy as so many appear to believe. What then drives the economy, other than money?

Dr. Nicolaus Berlin points his finger at our innate urge to activity which makes the wheels go round. Our rational selves calculate whenever possible, but eventually we fall back on innate motives, drives and chance. The young scientist provides empirical evidence that in addition to the profit motive there are seven non-economic motives - Animal Spirits - which drive economic change. He emphasizes their positive and creative forces and lays the foundation for an economic theory of motivation. This approach is of special importance today, as we have to cope with the rise of a new era, driven by a young generation of change makers. Be prepared for a radically new concept of economic thinking, exploiting instincts and Animal Spirits, for a new beginning.

Fredmund Malik

St. Gallen, October 2014

1. A Brief Account of Animal Spirits Driving Economic Change
1.1 Background and Literature

Standard economic theory does not take into account the significant degree to which economic actors are also guided by noneconomic motives. Mainstream economists followed the concept that economic actors are driven by self-interest and profit maximization, this was proposed by Adam Smith at the end of the 19th century. At the same time Thorstein Veblen pointed at the leisure class' consumer behavior and analyzed how economic dynamics are driven by noneconomic motives, such as emulation and status.

John Maynard Keynes coined the term animal spirits for inner drives and noneconomic motives, and declared these drives as indispensable for overcoming economic depression. He pointed at people who were rather active than inactive even in situations where, from an economic point of view, it was irrational. He did not provide a clear definition, this was a source of confusion. The term has been used to describe different things such as inner drives, sentiments and events of economic irrationality; for example, Akerlof and Shiller (2009) proposed irrational responses. The different approaches to animal spirits are illustrated in Figure 1.

A milestone was set by Joseph Schumpeter in 1911, who reasoned that the motive of profit maximization cannot explain economic change and development, which is fundamental to any sound economy. Schumpeter appointed the entrepreneur to be the carrier of the economic change process who is driven by three noneconomic motive families: dynasty building, the urge to fight and the joy of creating. Schumpeter suggests to study the entrepreneur as the carrier of these drives in the economic change process. In contrast to literature, which is predominantly concerned with analyzing animal spirits on a macroeconomic level, this dissertation focuses on empirical data from the individual level of entrepreneurs.

Seven animal spirits are proposed, based on literature by Veblen, Schumpeter, Keynes, Lawrence and Nohria, and many other scientists. The propositions strictly accord to the category of noneconomic motives, as illustrated in Figure

2. It is important to note that animal spirits have not been empirically tested before.

1.2 Research Question

Are any of the proposed animal spirits empirically verified in the sample of entrepreneurs?
I. Hunting - the drive to capture
II. Emulating - the drive for status
III. Competing - the drive to win
IV. Defending - the drive to protect
V. Bonding - the drive to belong
VI. Curiosity - the drive to explore
VII. Creating - the drive to build

Economic change is the place to look for animal spirits. Schumpeter suggests that animal spirits can be observed in reports and biographies of entrepreneurs, the carriers of the change process. Accordingly, the sample of the dissertation focuses on entrepreneurs and reports of their ventures. These data are processed with the method of qualitative content analysis. A category definition was formulated before applying the technique of inductive category formation to the reports. Economic and noneconomic motives that drive entrepreneurial activity are derived from reports.

A sample of 20 male entrepreneurs, consisting of eight "greenhorns" at age 24 - 30, and twelve experienced entrepreneurs at age 35 - 75, agreed to be studied. The industries include finance, real estate, e-commerce, advertising, fashion, retail, healthcare food and drink. 13 entrepreneurs have a university degree, six have a high school degree and one has completed a traineeship. Ten have started their business straight out of school or university, seven had worked as an employee before starting their venture and three joined their family business straight after completing education. The author visited them in their offices in Germany and Austria, and audio recorded reports on their ventures, which include data on the outcome of the ventures as well as personal data of the entrepreneurs. The interview guide can be found in Appendix I.
1.3 Results: Empirical Evidence of Animal Spirits

Data provide evidence of seven animal spirits that drive entrepreneurs.
1. Independence - the drive for autonomy
2. Hunting - the drive to capture
3. Emulating - the drive for status
4. Competing - the drive to win
5. Bonding - the drive to belong
6. Curiosity - the drive to explore
7. Creating - the drive to build

The drive for independence has not been proposed, however empirical evidence demanded it to be added to the list. Based on literature the animal spirit of defending was proposed, however it has not been found in any report of 20 entrepreneurs. Consequently it is not defined as an animal spirit that drives entrepreneurs.

What stands out in Figure 8 is the dominance of three drives - creating, independence and exploration. Additionally, entrepreneurial activity is driven by the two categories on the right: opportunities & setbacks and the profit motive. 11 entrepreneurs (55?% of the sample) reported that opportunities and setbacks played a significant role in triggering entrepreneurial activity. Fifteen entrepreneurs reported that the profit motive also stimulated entrepreneurial activity.

Entrepreneurs are driven by different combinations of animal spirits. These driving forces of entrepreneurial activity do not appear in isolation, but in combinations. Four groups are selected: Internet entrepreneurs, pioneer entrepreneurs, angel entrepreneurs and senior starters. As Figure 9 illustrates, the groups are characterized by distinct patterns of animal spirits.

Internet entrepreneurs are primarily driven by three animal spirits: independence, creating and exploring. Doing their own thing is of high value to this group; creating new combinations and transforming the online world is their driving vision.

The pioneer entrepreneurs created the largest number of jobs. They are driven by creating, exploring, competing and bonding.

Angel entrepreneurs have founded venture capital companies in order to finance and nurture startups. A characteristic of this pattern is the strong focus on the drive for independence, which appears to be the sole driver along with a sound profit motive. Unlike others, angel entrepreneurs do not have the drive to bring the new to the economy themselves, but they support others in doing so.

Senior starters faced the highest risk and entrance barriers when starting their businesses. They were in a phase of life where they had to live up to the high expectations of family and status. What stands out in this pattern is the energy resulting from interaction with the environment. Frustration -resulting from suppressed desires for independence - is transformed into entrepreneurial energy, opportunities and setbacks are fundamental catalysts.

A small sample did not fit to any of the four patterns and has been left uncategorized.

1.4 Conclusions

Entrepreneurs have a fundamental function in the economy as they create new combinations, which displace old and obsolete structures. This creative destruction is central to the economic change process. The significant role of the entrepreneur cannot be explained with the profit motive and maximizing self-interest. The data provide evidence that the carrier of the economic change process, the entrepreneur, is also driven by noneconomic motives. Without animal spirits, neither creative destruction, nor the economic change process can be explained. Economic theory is incomplete without incorporating these drives.

The dissertation provides empirical evidence that animal spirits are part of noneconomic motives driving entrepreneurs and that animal spirits coexist with profit motive and self-interest, as driving forces of economic change.

An alternative view is presented, contrasting the negative image of animal spirits. On the macroeconomic level, economists are aware that economic actors are also driven by noneconomic motives, however, they focus on abnormal times, on crises and irrational exuberance. Policy makers blame animal spirits for causing bubbles and busts, for example the credit crisis of 2008. Animal spirits, as aberrations from economic rationality, from self-interest and profit motives have been doomed as demonic and destructive; that triggered a debate on inhibiting animal spirits.

In contrast, this dissertation shines light on the positive and constructive forces of animal spirits arguing that economic change cannot be explained with economic motives alone. Unlike standard economic theory suggests, the profit motive by itself is not sufficient to overcome the great barriers that inhibit economic change. Noneconomic motives by themselves are not sufficient either. The data indicate that it requires a fusion of both forces, profit motive and animal spirits for progress in economic theory and a deeper understanding of what drives economic actors.

2. Setting the Stage

In the book Animal Spirits, Akerlof and Shiller (2009) argue that the global financial crisis delivered evidence once more that powerful psychological forces are driving financial markets and create bubbles and busts. The real problem is that the conventional wisdom - Efficient Markets Hypothesis (EMH) and homo economicus - blinds us.

"So many members of the macroeconomics and finance profession have gone so far in the direction of 'rational expectations' and 'efficient markets' that they fail to consider the most important dynamics underlying economic crisis. Failing to incorporate animal spirits into the model can blind us to the real sources of trouble. [...] Conventional economic theories exclude the changing thought patterns and modes of doing business that bring on a crisis. [...] All of these exclusions from conventional explanations of how the economy behaves were responsible for the suspension of disbelief that led up to the current crisis. They are also responsible for our current failure in knowing how to deal with the crisis now that it has come." (Akerlof and Shiller, 2009, p.?167)

The authors argue that it is essential to include animal spirits in macroeconomic theory in order to understand what really drives markets and how crises form.

"In this respect the macroeconomics of the past thirty years has gone in the wrong direction. In their attempts to clean up macroeconomics and make it more scientific, the standard macroeconomists have imposed research structure and discipline by focusing on how the economy would behave if people had only economic motives and if they were fully rational." (p.?168)

Akerlof and Shiller (2009) explain the gaps formed by the ignorance of behavioral factors in macroeconomic theory along the following matrix.

Figure 1 illustrates that current macroeconomic theory only fills the upper left box (1) of economic motives and rational responses. Differentiating between economic and noneconomic motives with rational and irrational responses reveals that standard economic theory only answers the question of how the economy develops when people are driven solely by economic motives and respond entirely rational. What it does not answer is how the economy behaves (2) when people are driven by noneconomic motives, such as emulation, and respond rationally. Neither does it explain how the economy behaves (3) when people are driven by economic motives and respond irrationally. It also does not explain the dynamics (4) when people are driven by noneconomic motives and respond irrationally.

There is an urgent need to gain a better and more realistic understanding of the dynamics that sway financial markets and economies. In order to advance the comprehension of this area we need to better integrate the behavioral knowledge into the science of economics. The first part of the dissertation accumulates historic sources and literature from various social sciences that contribute to our general understanding of the driving forces we call animal spirits. It aims at merging the historic, yet highly current contributions to animal spirit research from various academic fields. The problem at hand is that the dynamics of animal spirits fall into many different scientific areas - ranging from sociology, psychology, anthropology, to finance and economics - and thus no coherent picture has been drawn yet for their role in economics.

Theoretical sources and historic evidence reveal that animal spirits are real forces driving real people. That these drives are unaccounted for in macroeconomic theory is a source of criticism. At the focus of this dissertation on animal spirits are the dynamics responsible for economic change. Coping with entrepreneurial uncertainty, bringing the new to the economy and driving change cannot be explained when exclusively considering profit motives and self-interest. Animal spirits are part of that equation. How else could we explain why so many entrepreneurs take immense risks, even though chances of success are minimal?

3. Do Animal Spirits Matter? - A Literature Review

It was a great surprise to discover the prosperity of literature that indicate the forces of animal spirits. Research in literature uncovered a rich diversity observed by Veblen, Le Bon, Keynes, Schumpeter, Riesman, von Hayek, Drucker, Schelling, Soros, Schleifer, Shiller, and Akerlof, to mention a few. It became evident that the contributions to animal spirits research are crossing many disciplines, such as anthropology, sociology, economics, psychology, philosophy, finance, management, and biology. The wide span of disciplines can be systematically assembled, analyzed, summarized, and applied to the fields of economics and finance. The method of choice to research the large variety of animal spirits is a literature review, beginning in 1899.

The new insights on animal spirits serve to improve our understanding of the behavior of economic actors with the aim to explain events that standard economic theory is not yet capable of explaining in its entirety. For the purpose of clarity and to counteract and prevent from falling prey to the confusion around the meaning of the term "animal spirits", the following key points outline its meaning.

- Animal spirits are characterized by a spontaneous urge to action; a subconscious, inner drive to act.
- Animal spirits are primary drives that are independent from one another in the sense that nourishing one will not satisfy the others.
- Generated by evolution, animal spirits can at times work against rational self-interest. At their strongest, animal spirits can overpower comparison and rational choice.
- Animal spirits are in their nature noneconomic motives, yet many are relevant for economics, as they can trigger economic actions.
- Animal Spirits are proactive drives.
- For the purpose of this dissertation, only economically relevant inner drives are considered.

3.1 Animal Spirits - Definition, Function and Confusion

"Keynes' animal spirits are the keynote to a different view of the economy - a view that explains the underlying instabilities of capitalism."

"Macroeconomists have found it difficult to formalize the concept of animal spirits on their own terms, and so they have largely neglected it."

Akerlof and Shiller, 2009, p. xxiii, p. viii

The term animal spirits was coined by John Maynard Keynes (1936/1964, p.?161-162) when he was in search of answers to the burning question: What are the forces that could drive economies and markets out of the Great Depression? He identified the dynamics of animal spirits, describing them as follows:

"A spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."

When rational economic drives are debilitated, as in the Great Depression of the 1930s, psychological forces override and rule the markets. In Keynes' view the economy is not only run by rational actors. He agreed that much of economic activity is a result of rational economic motivations. However he emphasized that economic activity is also guided by animal spirits and he attributed the cause for fluctuations in the economy largely to these dynamics. He was not the first to appreciate that people also have noneconomic motives and do not always rationally pursuit their economic interest.

Long before Keynes, Thorstein Veblen had already analyzed the impact of noneconomic drives and psychological forces on the economy in The Theory of the Leisure Class. Based on observations of wealthy people, Veblen (1899/1912) drew the conclusions that people are "irrational, economic creatures who pursue social status with little regard to their own happiness". Unlike the then dominant economists, who defined human beings as utility-driven, rational individuals that crave to maximize their own pleasure, Veblen was the first to point at the noneconomic drives of emulation.

Adam Smith (1759) was fully aware of sentiment and feelings that play an important role in economics, he even devoted an entire book to this subject entitled The Theory of Moral Sentiments. It failed to be a success. In his bestselling book, The Wealth of Nations, he put the selfish-man at the core of the economic theory, which made him famous and became the bible for free-market theorists for a hundred years. Smith's economic actor chases primarily his own gain and is "led by an invisible hand to promote an end which was no part of his intention" (Smith, 1776/1994, p.?465). Smith's thoughts on animal spirits - he entitled them propensities - are discussed in two chapters of this dissertation: Emulating - The Drive for Status and Bonding - The Drive to Belong.

3.1.1 Confusion

The purpose of this dissertation is to clarify how animal spirits influence the economic change process. Standard economic theory does not take into account the significant degree to which economic actors are also guided by noneconomic motives, which include inner and subconscious drives. When Keynes coined the term animal spirits he did not provide a clear definition, this was a source of confusion. Based on a lack of clarity and definition, many economists interpreted animal spirits differently and in their own way. The term has been used to describe three different things: inner drives, sentiments, and events of economic irrationality. Consequently, the term has acquired different, vague and inconsistent meanings.

Figure 2 illustrates how Akerlof and Shiller (2009, p.?3) contributed to the confusion, as they entitled their book Animal Spirits, while they focus on a variety of psychological factors that influence economic behavior, but not on noneconomic motives. They point out that the original use of the term spiritus animalis translates to 'the spirits of the mind'. It is the life force and the basic mental energy they are referring to. Animal spirits can function as an unseen force that can refresh and energize and at times help to overcome hesitation and fear. However, in modern economics it refers to the odd relationship we have with uncertainty or ambiguity. Ambiguity inhibits the process of decision-making and paralyzes the economic actor. As a tool to explain anomalies that conventional macroeconomic theory alone cannot justify, Akerlof and Shiller (2009) identified a list of five psychological factors that they believe to be of particular importance: confidence, fairness, corruption and bad faith, money illusion, and storytelling. The suspicion that it was animal spirits that energized the financial crisis is likely a reason why Akerlof and Shiller predominantly consider the negative and unpredictable side.

The former Chairman of the Federal Reserve of the USA, Alan Greenspan (2013, p.?9), sees animal spirits as sentiments and focuses on the interplay between fear and euphoria. "I seek to identify specific behavioral imperatives - spirits - such as euphoria, fear, panic, optimism, and many more - and explore how they, and the cultures they foster, interact with rational economic behavior and spur important market outcomes." Greenspan has come to the perspective that there is something systematic about the irrationality of people's behavior, especially in periods of economic boom and economic depression. He suggests that animal spirits driven behavior should become a fundamental part of economic policy and economic forecasting.

What is common to all interpretations of animal spirits is that they are a strong source of energy. These energies, whether conscious or subconscious, defined or undefined, refer in all interpretations to the enormous drive to overcome despair, uncertainty and paralysis. In order to generate an appropriate mindset and assist the understanding of animal spirits, comparing them to the dynamics of a river proved to be a good guidance. Under normal conditions, the water flows in a consistent and balanced stream. At times however, the same calm river can turn into an impetuous stream of water that destroys the landscape, drags out trees and destroys the waterside. In dry periods, however, the impetuous river can die out and seem to be non-existent. Under certain conditions, animal spirits provide an economic actor with a balanced stream of energy that pushes him forward, not too much and not too little. At other times, however, they can promote excesses and wild behavior that can have disastrous effects on markets and economies. Under further different circumstances animal spirits can be poisoned. Economic stagnation and paralysis is the result of animal spirits that have been poisoned, wounded, and starved.