Irrationality and Emotion Will Kill the Economy

What’s the Latest Development?

World stock markets suffered their biggest losses last week since the crash of Western finance giants set off a world-wide credit crisis in 2008. But if the economy continues to decline, it will be for reasons vastly different from those which precipitated the credit crunch. This time around, the American economy is adding jobs but investors are being spooked by a feckless Washington, says George Magnus, senior economic adviser at U.B.S. in London. While the first crash was a real crisis of cash, the potential double-dip will be all about psychology. 

What’s the Big Idea?

Why do markets crash even when very little material wealth has been destroyed? Perhaps because today’s financial instruments have increasingly little to do with real wealth. “Behavioral economic theories, which focus on the psychology of finance, predict that, at times, irrational thinking and emotion will prevail, leading hordes of people to spend more and more on investments instead of recognizing that they are overpaying only to later stampede out of the market in a panic, precipitating a crash.”