The Confidence Fairy versus the Animal Spirits—Not Really a Fair Fight

The humor columnist for the New York Times, Paul Krugman, has recently taken to defending his vulgar Keynesianism against its critics by accusing them of making arguments that rely on the existence of a “confidence fairy.” By this mockery, Krugman seeks to dismiss the critics as unscientific blockheads, in contrast to his own supreme status as a Nobel Prize-winning economic scientist.

The irony in this dismissal, as others, including my friend Donald Boudreaux, have already pointed out, is that Krugman’s own vulgar Keynesianism relies on a much more ethereal explanatory force for its own account of macroeconomic fluctuations—namely, the so-called animal spirits. The master himself wrote in The General Theory: “Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die.  . . . [I]ndividual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits. . . .” (p. 162). Because Keynes conceived of his “animal spirits” as “a spontaneous urge to action rather than inaction” (p. 161), he of course had no way to explain their coming and going or to measure or evaluate them in any way. They are as surreal as a ghost—when and why they come and go, no man knows or can know.  Such is the force that drives the ups and downs of private investment in Keynesian economic theory, and such theory unfailingly drives Krugman’s commentaries on the recession and on the possibility and effective means of recovery from it.

Regime uncertainty, however, has a much more grounded basis. In my own research on the topic, I have presented evidence derived from (1) a mass of testimony by investors, businessmen, and other contemporaries, (2) voluminous historical facts on the character of government actions that reasonable people had every reason to interpret as theatening the security of their private property rights, (3) variations in the structure of investment, especially as between short-term and longer-term projects, and (4) specific twists in the term-structure of returns on private corporate bonds, as well as other relevant evidence on the behavior of financial markets.

As against this varied and substantial evidence, what does the proponent of animal sprits have to offer? Well, nothing at all. The idea is purely fanciful, the product of Lord Keynes’s fertile imagination.

However, we would do well to note that in the section of his book where Keynes introduces the idea of animal spirits, he also discusses it in a way that makes its effects somewhat similar to those of regime uncertainty as described in my own writings.

This [operation of varying animal spirits] means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man. If the fear of a Labour Government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent;—it is the mere consequence of upsetting the delicate balance of spontaneous optimism. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.” (p. 162, emphasis added)

Although Keynes greatly underestimated the degree to which investors’ expectations about the security of their property rights rest on perfectly rational grounds for fearing what a Roosevelt administration or an Obama administration might do, he recognizes that, whatever the basis for variations in the flow of animal spirits, business confidence plays an essential part of driving private investment. Paul Krugman, please reread your master’s masterpiece.