Animal spirits in financial economics: A review of deviations from economic rationality

John Keynes made the notion of animal spirits a central part of economics in 1936. However, recent financial literature is dominated by asset pricing models based on strict economic rationality and struggles to accept the notion of animal spirits. This essay is an overview of the causes and consequences of financial market inefficiency and failure and the role of animal spirits in finance. Unlike prior literature, it combines insights and evidence from multiple fields such as finance, economics, psychology, and politics, to understand the many reasons for market failure. It then uses this understanding to develop five simple practical principles to guide regulations required to mitigate the effects of market failures. The results should be of much interest to finance scholars, money managers, business executives, and policy makers.