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Policy paper from the Federal Reserve Bank of Boston examines financial panics

The Federal Reserve Bank of Boston has issued a policy paper that’s a deep dive on financial panics -- from the psychological perspective.

The paper looks not just at standard economic explanations for panics like the one in 2008 but at the human traits that may drive them. To understand, writers Anat Bracha and Elke U. Weber suggest exploring “animal spirits,” an expression used by John Maynard Keynes in a 1936 book to describe the human emotions that he saw linked to consumer confidence.

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The root of panics from the Great Depresssion and the dot-com collapse to the latest recession, the authors argue, lies in our willingness to believe the boom times, when they come, won’t end. Investors believed, for instance, that the tech bubble of the late 1990s wouldn’t burst, and that real estate prices before the 2008 subprime mortgage crisis would never fall.

When reality hits and those blindly optimistic views are dashed, panic ensues.

“The illusion of control refers to the human tendency to believe we can control or at least influence outcomes, even when these outcomes are the results of chance events,’’ the Fed paper says.

It works something like this: The market goes up for months, or years, as the case may be. It seems irrationally good. But everybody’s on board, so it keeps going up. It starts to feel predictable, comfortable, not unlike gamblers at the craps table, who come to feel they can control the roll of the dice, Bracha and Weber write.

This sense of predictability and control engenders confidence and has contributed to successful human evolution.

“This sense of predictability gives investors a feeling of control, which then legitimizes further opportunity seeking ... that is often riskier than it is perceived to be,’’ the authors write.

But when the illusion of control is pierced, confidence is dashed, and humans react with an outsized sense of danger -- retreating from the overconfidence they allowed themselves before.

“Resulting behavior, including a retreat to safe and familiar options, aims to minimize exposure to such danger until a new model of how things work has been established,’’ the paper says.

So what’s the antidote to this hard-wired search for control, and the urge to flee when that falls apart? The writers suggest policymakers come up with a cheerier narrative to head off future financial panics “and narratives of gloom and doom.”

Or, the government can do what it did last time -- pump billions of dollars into the financial system to shore up confidence, and lend investors that oh-so-illusory sense of control.

Beth Healy can be reached at bhealy@globe.com.
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