The Psychology of Financial Fear
Fear isn’t just an emotion in financial markets – it’s a powerful force that can reshape entire economies. When investors see others buying a particular stock, they often follow suit, fearing they’ll miss out on potential gains, but when panic strikes and everyone starts selling, individual investors often join the stampede, terrified of holding onto a sinking ship. This fear-driven behavior has deep evolutionary roots, stemming from our ancestors’ survival instincts that made following the group literally a matter of life and death. Risk can be characterized as a feeling and feedback effects can intensify fear responses to evaluations of risk, precipitating panics, while emotional factors such as nervousness or euphoria can induce shifts in aggregate demand in ways that cannot be explained just using economic analysis, with greed, hope and fear being the emotions most relevant to financial decision-making.
How Fear Spreads Through Financial Networks
Financial contagion works much like a virus, jumping from one institution to another through interconnected networks of fear and uncertainty. Contagion is defined as the spill-over of effects including fear and anxiety, caused by an extreme negative event in one location as it moves to affect others, and we expect an increase in fear to alter rational consumer behaviour, with contagion effects likely increased through increased international media communication and access. Modern technology and global media have amplified this effect dramatically, making financial panic spread faster and wider than ever before. Understanding the scope of the role of the media in influencing changed consumer patterns of behaviour is increasingly important in our globalised world where technological advances have extended traditional domestic news stories to international audiences, such that the media has come to play a larger role in the promotion and intensification of consumer panic and anxiety.
The speed at which fear can now travel is unprecedented. What once took weeks to spread across continents now happens in mere minutes through social media and instant news cycles. This acceleration has fundamentally changed how financial crises unfold, making them more intense but sometimes shorter in duration.
Banking Panics of the Great Depression Era
The U.S. appeared to be poised for economic recovery following the stock market crash of 1929, until a series of bank panics in the fall of 1930 turned the recovery into the beginning of the Great Depression. The collapse of Caldwell and Company in 1930 triggered a wave of fear that spread far beyond its immediate geographical boundaries. After the collapse of Caldwell and Company, the largest bank-holding company in the South, runs on banks became widespread, with the calling card of a panic being the suspension of numerous banks in close proximity in a short period, such as within ten miles and 30 days.
The data demonstrate that the average number of weekly bank suspensions doubled after Caldwell’s failure in the fall of 1930, rising from 15.1 to 39.1, with panic-induced bank closures peaking in the last quarter of 1930 and in the last two quarters of 1931. Fear wasn’t just psychological during this period – it had concrete economic consequences. Between 1929 and 1932, the money supply and bank lending in the United States declined by more than 30 percent, with banking panics reducing lending in banks that remained in operation by $6.4 billion, nearly twice the $3.3 billion in loans and investments trapped in failed banks.
The Panic of 1907 and Trust Company Failures
The 1907 crisis demonstrated how fear could cripple financial institutions that seemed solid just days before. Runs on trust company deposits short-circuited their role as the initial liquidity provider to the stock market, as brokers used these loans to purchase securities and then used these securities as collateral for call loans from nationally chartered banks, but runs on trust company deposits short-circuited their role as the initial liquidity provider to the stock market. The crisis revealed how interconnected the financial system had become, with trust companies serving as crucial links in the chain of market liquidity.
The Panic of 1907 had severe real effects, with industrial output falling 17 percent in 1908 and real GNP falling by 12 percent – only the Great Depression was more severe. What made this crisis particularly devastating was how quickly fear could spread through New York’s financial district, where institutions that had seemed rock-solid suddenly became suspect in the eyes of depositors and investors alike.
The Modern Echo of 2023 Banking Failures
In March 2023, Silicon Valley Bank lost a quarter of its deposits in a single day and was quickly shuttered by regulators, becoming the second-largest bank failure in U.S. history at the time of its collapse, with SVB ($209 billion in assets) and Signature Bank ($110 billion in assets) being the second- and third-largest bank failures in U.S. history. The speed of these failures was breathtaking even by modern standards. Their failures were also exceptionally quick by modern standards, as by comparison, Washington Mutual, the largest bank failure in American history, lost 10 percent of its deposits over the course of 16 days in September 2008.
In the days surrounding the failures of SVB and Signature Bank, depositors fled banks with assets between $50 billion and $250 billion, moving their money primarily to larger institutions, with a total of 22 banks experiencing runs in March according to research, and the three failed banks collectively holding more assets than all bank assets lost in the 2008 financial crisis. This demonstrates how fear in the modern era can produce losses that rival or exceed those of previous major crises, but compressed into much shorter timeframes.
Herd Mentality in Financial Decision Making
Trading in financial markets is characterized by herd behavior to a large extent, with fear response driving investors to imitate what other investors are doing without conducting their own analysis to mitigate the risk of failure in times of market uncertainty. This isn’t simply irrational behavior – it’s a deeply ingrained survival mechanism that served our species well in prehistoric times but can be disastrous in complex financial markets. A study has shown that herd-decisions are associated with shorter decision-making times, suggesting that herding is an intrinsic, emotional response and a more automatic decision-making heuristic.
Herd mentality occurring in financial institutions makes people act the same way or adopt similar behaviors as the people around them, often ignoring their own feelings and sense of judgment, causing many people to ignore risks as others were ignoring them. During the 2008 crisis, this collective blindness to risk became particularly evident as institutions that prided themselves on sophisticated risk management simply followed what their competitors were doing, rather than conducting independent analysis.
Fear-Driven Monetary Contraction
The monetary explanation for the Great Depression shows that bank failures and bank runs cause a contraction of the money supply, which causes a decline in spending, investing and GDP. When people become afraid, they don’t just change their investment strategies – they fundamentally alter their relationship with money itself. In the 1930s, people saw their neighbor’s bank fail and the rational thing to do was run to your bank, get all your money out, put it in a coffee can, and bury it in the backyard or stuff it under your mattress, wanting to hold wealth in the form of cash because it’s the only asset you can really count on since you can’t count on your bank deposit because you don’t know if tomorrow your bank will still be open.
The crises generated deflation because they convinced bankers to accumulate reserves and the public to hoard cash, with hoarding reducing the proportion of the monetary base deposited in banks while accumulating reserves reduced the proportion of deposits that banks loaned out, together reducing the supply of money, particularly in checking accounts which were the principal means of payment.
The Role of Confidence in Economic Stability
Following Keynes, if the state of confidence is strong and people are optimistic, then the macro-economy will be vulnerable to waves of euphoria, optimism and overconfidence, precipitating herding and speculative bubbles; but when the state of confidence is weak and people are pessimistic, then the macro-economy will be prone to slumps and financial crises. Confidence isn’t just a nice-to-have in economic systems – it’s the invisible foundation that everything else rests upon. Keynes’s psychological forces include not only the propensity to consume from income and the desire to hold money but also the waves of optimism and pessimism that affect stock markets, and the animal spirits that propel entrepreneurship, along with sociological forces affecting investors, such as the socially propelled conventions that encourage speculators to believe what others believe and to do what others do.
Without confidence, even the most sophisticated financial institutions can crumble overnight. With too much confidence, markets can inflate to dangerous bubbles that inevitably burst. The challenge for policymakers has always been finding that delicate balance between encouraging healthy optimism while preventing dangerous euphoria.
Current Recession Risks and Fear Indicators
J.P. Morgan now sees a 40% probability that the U.S./global economy will enter a recession by the end of 2025, with J.P. Morgan Research having reduced the probability of a U.S. and global recession occurring in 2025 from 60% to 40%. Despite this relatively optimistic revision, many factors can trigger or contribute to a recession, with tariffs and inflation being the biggest risks to economic stability in 2025, as President Trump has implemented or threatened to implement aggressive tariffs on goods imported from China and other U.S. trade partners.
The subjective view is that the chances of a recession are 20%, which reflects the possibility of a policy mistake made by the incoming Trump administration with respect to tariffs and the risk its policies could incite a global trade war. Current fears aren’t just about domestic policy – they reflect the interconnected nature of modern global finance, where decisions made in Washington can trigger reactions in markets from Tokyo to London within hours.
Fear remains a constant undercurrent in financial markets, shaped by everything from policy uncertainties to geopolitical tensions. A 2007-scale financial shock today would result in 8.7 million people losing their jobs by 2026, with employment not recovering to current levels until 2031, and the loss in real GDP per capita over the next five years would be $7,774. These projections remind us that the costs of financial fear – when it materializes into actual crisis – remain as devastating as ever, even in our modern, sophisticated economy.