Although the news around the financial crisis continues to worsen, an equally important and self-perpetuating component of this crisis is people’s reaction to the news.

Where We Are In The Crisis

To re-iterate: It has been obvious for two years that a recession was inevitable, and it is likely we will see more losses for real people and companies of all sizes before we get through this.

That the crisis is spreading in a logical manner was indicated by GE’s announcement on Friday that they are seeing rising consumer defaults: GE takes hit as consumers default on debt. The next step is slowing retail sales, failures by more companies exposed to these sales, more layoffs, etc.

However, a recession does not mean the economy does not continue to function, and some losses does not mean everyone will lose their job or savings.

We have seen recessions before and we will see them again, and we will be ok. It is all a part of capitalism!

Dealing with the reality of how this crisis has unfolded has been hard because – like everywhere else in life – predicting the future of how people react is very difficult.

The “Markets” = People

We can not lose sight of the fact that, at base, these markets are comprised of individuals or computer programs built by individuals. When the complexity of predicting human behavior is multiplied by a series of financial innovations like derivatives and highly levered institutions with connections across global capital markets, predicting the outcome of shocks becomes nearly impossible.

If I was better at math, I would draw a fancy formula to “prove” such a proposition, but like most true things in life, it seems obvious without much explanation.

One of the most difficult aspects of this predictive process is figuring out how individual decision-makers (including bankers, investors and consumers) will react to the ongoing crisis. This is important because pessimism can make a bad problem worse.

The recent downward spirals in markets from the LIBOR market to the stock market to the local corner market are partially based on the reality of weakening fundamentals in the economy, but they are also based on a normal human reaction to bad news.

People = Irrational

Jeremy Grantham of GMO, one of the smartest investors around in my opinion, talks about how “career risk” is a very important element to understanding market movements. When everyone is buying, it is more risky for your career to be the one to stop buying first…and today, when everyone is selling, if you are the first one to start buying and you are wrong, it might look bad to your boss.

I think this explains part of the herd mentality that we are witnessing.

However, I think part of it is also explained by something like The Kübler-Ross grief cycle:

The initial state before the cycle is received is stable, at least in terms of the subsequent reaction on hearing the bad news. Compared with the ups and downs to come, even if there is some variation, this is indeed a stable state.

And then, into the calm of this relative paradise, a bombshell bursts…

* Shock stage: Initial paralysis at hearing the bad news.
* Denial stage: Trying to avoid the inevitable.
* Anger stage: Frustrated outpouring of bottled-up emotion.
* Bargaining stage: Seeking in vain for a way out.
* Depression stage: Final realization of the inevitable.
* Testing stage: Seeking realistic solutions.
* Acceptance stage: Finally finding the way forward.

As people across the economy, in whatever role they are playing, get the bad news that the world is in a more disappointing state than they expected, it is only natural that they will react with grief. As explained by they framework above, this is usually experienced in distinct phases marked by one’s emotional response and mental reaction.

Of course, this theoretical framework, like every framework, is limited and it likely does not apply to everyone, but I think it highlights the basic idea that people do not act rationally when they are faced with shocks to their world view.

They – being human beings – react emotionally as well as rationally.

That is why I have been trying to shift my focus to optimism as much as possible lately. Seeing the glass as half-full, or even one-quarter-full, makes it much easier to start thinking about ways to move forward. It helps to move to the next “stage” in the above cycle, or more simply, it allows for one to think creatively about how to improve things rather than wallowing in the disappointment of the losses we face.

I can promise you that there will be more bad news on the television and on the Internet tomorrow and for months to come. But there will also be good news. I hope that we can collectively deal with our losses and griefs in such a way that allows us to move forward more quickly than the alternative, and I think that starts by seeing the good in the world.

In the mean time, be careful out there in the markets.