Sheep graze in the recultivated rubbish mould of the waste management company "Getlini EKO" in Riga, Latvia, June 30, 2015. A Soviet-era rubbish dump in a swamp on the outskirts of Riga was once an obstacle to Latvia's EU membership. Now, it's becoming a model of the resource-use and waste management EU policy-makers are striving to promote. Picture taken June 30, 2015. REUTERS/Ints Kalnins

This article was first published in the second-quarter 2016 edition of Personal Finance magazine.

How important is herd or group psychology in determining real-life outcomes? Economists hotly debate this question.

The famous economist John Maynard Keynes (1883–1946) believed that an economic slump comes about because of a sudden general loss of confidence among business owners. Keynes did not seem too concerned about the cause of such events; instead he turned his attention to arguing that waning “animal spirits”, as he referred to the psychology of the herd, would result in a downward economic spiral. Business owners, he argued, would delay new projects and investments, causing hiring and economic activity to slow down. This would cause a slowdown in consumer spending, which would dent confidence further ... and so on: a vicious circle.

Keynes argued that this process would inevitably lead to a devastating depression unless the government borrowed and printed money and spent it in the economy. This approach would supposedly lift the animal spirits of the business community once more, and the economy would again be on its merry way.

That is a staggering argument. It essentially says that once market sentiment sours even a little bit, it runs the risk of plunging the entire system into chaos. It assumes that the economic system is both fragile and unstable. In making assumptions about group psychology, it leaves some enormous gaps, such as largely ignoring why confidence drops in the first place, the social value of curtailing excessive exuberance, why economic systems exhibit so much stability even when there is no significant state intervention, and why confidence can recover through the natural corrective forces of the market.

Keynes cops justified criticism for these omissions, but perhaps we shouldn’t throw Keynes’s animal-spirits baby out with the psychological bathwater.

Few would deny that psychology, particularly herd or group psychology, plays a significant and intricate role in shaping the way economies and markets function. But the real question is: should our governments be in the business of trying to manipulate group psychology, or should they concentrate on the business of governing? Propaganda, spin, hiding information, heavy-handed fiscal and monetary intervention, and so on are all things we associate with authoritarian states and oppressed societies.

Most politicians play the group-psychology manipulation game. I like to call government economic policy a game of MOPE – management-of-perceptions economics. No matter the underlying reality, policymakers make carefully worded, upbeat, unspecific, or spun statements about their policies and economies. The risk of igniting a herd psychological reaction, over which they may have little or no control, terrifies them. They try to instil calm and present their schemes as credible, but often this diverges from the reality people are experiencing. Policymakers may be able to fool some of the people some of the time, but certainly not all of the people all of the time. The herd may be psychologically misled for a while, but this usually only makes the convergence between perception and reality that much more acute and painful when it comes.

Perhaps the most enormous, high-stakes, live experiment in mass psychology manipulation is the communications policy of the United States’s central bank, the Federal Reserve. In the way it conducts monetary policy these days, the Fed is meticulous about every word in its communiqués and statements, to avoid kicking the herd’s psychological hornets’ nest. The Fed tries to read the market’s general psychology. The market then tries to fathom how the central bank has interpreted its psychology, which influences market psychology further. The bank then attempts to discover the new path of market psychology, and on and on it goes.

It’s not hard to see that this game of psychological cat and mouse can quickly become a rather absurd charade, often collapsing back in on itself like a dying star. The more a policymaker relies on group-psychology manipulation, the more likely it is that the underlying reality is far more dysfunctional than generally perceived and than policymakers want to let on. The further psychological perception diverges from reality, the more unstable a market or economic system can become.

When President Jacob Zuma fired finance minister Nhlanhla Nene in December, investors were unceremoniously dealt a dose of disillusionment. The precarious state of South Africa’s institutional governance structures became evident after years of spin had preserved the impression that these structures were rock solid. The reality-perception gap slammed shut.

We should fear the power of herd psychology, not as Keynes did, but when central planners and spin doctors manipulate that psychology to believe things are far rosier than they are. When reality-perception gaps eventually close (and they always do), you want to be sure you’re ready for it. Hell hath no fury like a panicked herd stampeding.

* Russell Lamberti is the chief strategist at investment advisory firm ETM Analytics. He is co-author of When Money Destroys Nations, a book about Zimbabwe’s hyperinflation crisis with lessons for the world.