I’m too afraid to use the phone. I’m too afraid to put the light on. I’m so afraid I’ve lost control, I’m suffocating without a word. Crazy with sweat, spittle on my jaw. What’s that funny noise, what’s that on the floor. Waves of fear, pulsing with death. I curse my tremors, I jump at my own step. I cringe at my terror, I hate my own smell. I know where I must be, I must be in hell. Waves of fear, waves of fear, waves of fear, waves of fear. These lyrics, from the 1982 song Waves of Fear, written and performed by Lou Reed on his album The Blue Mask may be describing the current economic and social environment.
At the height of the Depression of the 1930s the new President, Franklin Roosevelt famously stated in his first inaugural address, So, first of all, let me assert my firm belief that the only thing we have to fear is…fear itself — nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance. In every dark hour of our national life a leadership of frankness and of vigor has met with that understanding and support of the people themselves which is essential to victory. And I am convinced that you will again give that support to leadership in these critical days.
How times have changed. Now, in the midst of what can only be considered another depression, the country appears to be paralyzed with an unrelenting fear of the COVID-19 virus. Weather this is the result of the media machine with its constant drumbeat of statistics on the number of so-called cases, or it is the result of political campaigns playing the fear card to garner support for their candidates, it is fear more than anything that is keeping the economy from recovering.
With Halloween upon us, this is a perfect time to examine how fear can influence economic activity. Since at least the 1940s behavioral economists have been studying the effect of fear on economic actors. Generally, economics assumes that people will behave rationally, and will strive to achieve maximum utility (enjoyment) at the lowest possible cost. This assumption breaks down under a situation of extreme fear. Using magnetic resonance, experimental psychologists have observed that our brains react differently to situations involving extreme fear. This cold alter decision making processes and reduce the ability of people to make rational decisions under situations of uncertainty.
Financial economists understand that volatility can lead to more conservative investment decisions. In finance, volatility, or uncertainty is a proxy for fear, and even good investments might be discarded due to this form of fear. Uncertainty can also lead otherwise rational people to make irrational decisions. People tend to over-compensate for the potential of rare events, particularly when the consequences are unbounded. Take for example the call to invest trillions of dollars to attempt to stop the climate from changing. While it is unlikely that changes in economic activity will impact the climate in any meaningful way, the fear that humanity could be wiped out, no matter how small that probability, has led many to promote radical action.
Climate change is an illustration of the idea that humans try to maximize utility while minimizing the worst loses in the event of catastrophe. In effect, individuals are reacting rationally once the fear of extreme events is accounted for.
The current situation with COVID-19 is another example. While even the most dire predictions of Dr. Anthony Fauci, an individual who is well known to grossly overestimate the lethality of viral outbreaks, suggest that about 6-tenths of one percent of the US population could die from COVID-19, governments panicked and shut down the entire economy. Of course, a death rate of this magnitude is well below that of the 1918 Spanish Flu pandemic (about 2 percent) but the reaction was much more extreme.
Of course, as of today, using the broadest measure of COVID-19 deaths, the actual death rate is at most roughly 0.06 percent or just a tenth of what Dr. Fauci predicted. Even so, millions of Americans are still terrified of COVID-19 and refuse to leave their homes, visit family or travel.
It is this extreme fear that has crippled the economy. As an illustration consider the rule of thumb ‘maximize expected utility while minimizing the worst losses in the event of a catastrophe’. This rule is inconsistent with expected utility. Therefore, any observer that anticipates expected utility optimization will be disappointed, and will believe that there is irrationality at stake. But this is not true.
The rule is rational once we take into account rational responses to extreme events. It is consistent with what people do on an everyday basis, and with the experimental evidence on ‘jump-diffusion processes’ and ‘heavy tails’ distributions that are not well explained by standard theory.13 Purely finitely additive measures have also been considered in the work of Brown and Lewis (1981) when studying myopic economic agents, and in Gilles’ work on bubbles as equilibrium prices (Gilles, 1989).
The key to the new decision criteria that is identified here is to define ‘nearby’ in a way that is sensitive to rare events. This concept of ‘nearby’ is what I call a ‘topology of fear,’ one that can be sharply sensitive to catastrophes even if they are infrequent.14 A similar topology was used in Debreu’s 1953 formulation (Debreu, 1953) of Adam Smith’s Invisible Hand theorem.15 The rankings of lotteries that satisfy the new axioms for choice under uncertainty are a mix of ‘countably additive measures’ with ‘finitely additive measures’ with both parts present. This combination has not been used before except in Chichilnisky (1996a,b, 2000, 2002), Chichilnisky and Shmatov (2005) and Chichilnisky et al. (2005). These type of measures could play an important role in explaining how our brains respond to extreme risks.