Macro Mood Hysteresis

Bryan Caplan has some questions about how to apply mood to macro:

What would a full-blown mood theory of macro fluctuations look like?  Ideally it would begin at the micro level - with the individual psychology of traumatic events.  What exactly scares people, and how long do they stay scared?  Then we'd move to the social psychology of fear - how do we respond to other people's fear, and how does "social proof" affect individuals' emotional recovery? 


Empirically grounded mood theories will probably imply that fluctuations are (slowly) self-correcting even in the presence of total nominal rigidity.  The large literature on hedonic adaptation finds that even after blood-curdling experiences, normal people don't remain miserable/ fearful/ angry forever.  After six months or a year, people come to terms with what happened.  It's almost like they get bored of feeling afraid. 

Instead of focusing on hedonic adaptation, the interplay between confidence, catastrophe and engagement could be more enlightening.  One model that I have found useful is from Optimism & Pessimism: Implications for Theory, Research and Practice.  In chapter two, page 46, C.S. Carver and M. F. Scheier present a figure similar to the one below.

Optimists have higher confidence and will more often act in the face of adversity while pessimists will be less likely to put in effort if they think they are not going to succeed.  The change in effort from optimism to pessimism isn’t linear. After a certain level of negative feedback the optimist gives in to doubt and despair and stops trying and at some level of positive feedback the pessimist will decide that they have a chance and put in more effort.  This switch occurs in an area called the region of hysteresis, called such because the level of engagement depends on recent history.

During booms, the feedback investors get is generally positive and confidence is high*.  Minor downturns are generally shrugged off by the investment community and are generally seen as good buying opportunities.  The bust brings most investors down through the region of hysteresis as investors give up and decides to sell assets to protect their capital.  The reason the financial recovery is so rapid is partially due to the fact that many investors are jumping up through the region of hysteresis in the positive direction.  One reason the markets remain fragile today is that when it comes to systemic confidence, many people are still in or near their region of hysteresis where a large enough negative surprise can undo a lot of the recently regained confidence in the system.

*This is partially because the financial community consists of more optimists than pessimists, but that is a topic for another post.