Irrational pessimism can be very scary.

It was a grim day when the 32nd president of the United States of America took office. Banks were falling like trees in a clear cut. The economy was shrinking rapidly. Unemployment was soaring. Commodity prices were sliding and deflation had taken root.

This was the economic crisis Franklin Delano Roosevelt faced in 1933.

As I've written before, comparisons between the current economic crisis and that of the Great Depression are often glib and insensitive to the vast hardships suffered by so many in that much crueller era. But if not in degree, it's certainly true that there are parallels in kind, which is why it's worth recalling FDR's first statement on taking office.

"This is pre-eminently the time to speak the truth, the whole truth, frankly and boldly," the new president declared in his inaugural address. "Nor need we shrink from honestly facing conditions in our country today. This great nation will endure as it has endured, will revive and will prosper. So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself -- nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance."

Of course "nothing to fear but fear itself" has become one of the great clichés, but at the time it was a startling suggestion. After all, the situation was truly horrible. Eleanor Roosevelt even described her husband's inauguration as "terrifying," not least because FDR had narrowly escaped assassination only the month before. Nothing to fear but fear itself? Taken literally, this was nonsense. There was a very long list of things to fear aside from fear itself.

But Roosevelt understood something profound. Fear was both a cause and a catalyst of the crisis, he knew. And bad as the situation was, fear could make it much worse.

When people with savings in banks fear the banks will fail, they withdraw their money -- and cause the very thing they fear. When investors fear industry will decline, they will not invest -- ensuring industry will decline. When people with jobs fear unemployment, and when those with money fear deflation will keep forcing prices down, they will delay spending on consumer goods -- leading to job losses and deflation.
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Perceptions and expectations matter. Beliefs matter. Feelings matter.

"If the financial system has a defect," writes Harvard historian Niall Ferguson in The Ascent of Money, "it is that it reflects and magnifies what we human beings are like. As we are learning from a growing volume of research in the field of behavioural finance, money amplifies our tendency to overreact, to swing from exuberance when things are going well to deep depression when they go wrong. Booms and busts are products, at root, of our emotional volatility."

The best discussion of this fundamental fact can be found in Irrational Exuberance by Yale economist Robert Shiller. Published in 2000 as tech stocks soared to vertiginous heights, Irrational Exuberance called the market mania precisely what it was -- an unsustainable speculative bubble. In 2005, Shiller released a revised version of the book that identified the rapid rise in American home values as another bubble.

Although Irrational Exuberance focuses mainly on the mania side of the market's bipolar disorder, Shiller notes that the psychological dynamics which produce speculative bubbles can also generate the opposite.

Why did the stock market crash in 1929, he writes? It certainly wasn't "a response to any real news stories. We see instead a negative bubble, operating through feedback effects of price changes, and an attention cascade, with a series of heightened public fixations on the market."

Shiller's "attention cascades" are particularly important. Very simply, when many people believe something -- the economy is going down the drain, for example -- other people will often adopt the same view for no other reason than that many people believe it. As the number of people who share this belief grows, more people find it compelling simply by virtue of the fact that the number of people who believe it is growing. And so the belief keeps spreading. That's the "cascade" part.
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The "attention" component is the result of something cognitive psychologists call "confirmation bias": Once we believe something, we seek out and uncritically accept information that supports our belief -- while we harshly scrutinize, belittle, or simply ignore information that does not.

So as the cascade spreads and growing numbers of people become convinced the economy is going down the drain, they seek out information that supports their belief while dismissing or ignoring information that suggests otherwise.

This is how irrational exuberance generates more irrational exuberance and bubbles are inflated. It's also how irrational pessimism creates more irrational pessimism, driving markets and economies into a downward spiral.

Listening to the radio recently, I heard Shiller's thesis play out in miniature form.

A political panel was talking about the economy. It's bad. Really bad. People are suffering. And it will only get worse.

Then the host did something remarkable. He cited the latest economic indicators. They actually aren't so bad, he correctly noted. This isn't to suggest Canada won't suffer as the global recession deepens, he quickly added, but the way people are talking you would think we had soup lines, dustbowls and tramps riding the rails. Aren't we overdoing the gloom, he asked?

This intervention had no effect. One guest responded by talking about a town that had lost factories and how the people were hurting and afraid. Others chimed in with similar stories. The discussion continued as before, as if the statistics had never been mentioned.

This is irrational pessimism at work. And it's scary.

Today, as in 1933, we have real reasons to fear. But as in 1933, what we most have to fear is fear itself.

You can contact Dan Gardner at the Ottawa Citizen.
E-mail: dgardner@thecitizen.canwest.com

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