What’s the best way to scare a kid?  You wouldn’t just put on an ugly mask and chase him.  He might think it was a big joke and start laughing.  To be confident of a successful scare, you’d lay some groundwork first.  A week or two before the big event, you’d start warning him about a local monster, show him some pictures of the beast, and tell him some tales of its evil deeds.  You’d build up to the big day with gory descriptions and vague warnings.  That way, when you put on the mask and scream, you know you’ll be giving the poor kid the scare of his life.

Needless to say, Scaring kids is wrong and you shouldn’t do it!   I bring this up to illustrate a point: If you think that the recent stock market crash was a psychologically-fueled “panic,” it is quite likely that Paulson-Bernanke’s pre-crash fear-mongering was the crucial factor that sent investors over the edge.  If P-B had gotten hysterical without warning, the world might have just laughed at them – and expected them to retire to “spend more time with their families.”  Instead, they spent weeks building up the boogie man, giving us gory descriptions and vague warnings.  Psychologically speaking, this seems like a great way to put the world on the edge of its seat.  At this point, all it took to get the market to flee in terror was an ugly 7% decline.

I’m not sure that this story is correct.  But these days, it’s pretty hard to dismiss psychological theories of stock market movements.  And if you take psychological stories of financial markets seriously, it is quite plausible that Paulson and Bernanke’s Tales from the Crypt wound up creating the massive crash they were trying to avoid.  Doh!