In his first inaugural address, at the pit of the Great Depression in March 1933, Franklin Roosevelt famously said: "This great Nation will endure as it has endured, will revive and will prosper. 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." This was considerably overstated, since there was more to fear than fear itself, and the fear--given the unemployment rate of 25 percent and the fact that output had fallen by a third since 1929--was not unreasoning or unjustified.
But Roosevelt was on to something. A sharp drop in the economy--what we are experiencing today--can generate fears or anxieties that retard economic recovery. The explanation for this effect requires drawing a distinction between "risk" and "uncertainty." The former (for purposes of the distinction) is a risk to which a probability can be assigned--a calculable risk, such as a 20 percent chance of rain tomorrow. The latter word, "uncertainty," refers to a risk that cannot be quantified: the risk of a terrorist attack, for example. The two concepts actually form a continuum, because one can have more or less confidence in an estimate of a risk, less or more uncertainty.
Decisions by businesses to invest long term are examples of economic decisions that are made in a setting of considerable uncertainty, because so much that cannot be anticipated may happen to upset the expectations on which the investment was made and cause it to flop. Yet businessmen make such investments all the time. Are they rational in doing so? Well, they are collectively rational, because if no one were really to engage in a business venture without an exact knowledge of the risk, there would be no business, no economy. The human race would not have gotten far without a genetic predisposition toward venturing in circumstances of uncertainty. The ancestral human environment, in which we evolved, was pervaded by uncertainty, so that an extreme aversion to uncertainty would have frozen activity.
Some people are more averse to uncertainty than others, but--and here is the connection between the risk/uncertainty distinction and our current economic distress--almost everyone is more averse to uncertainty the greater the uncertainty is. This is implicit in such expressions as "fear of change" and "fear of the unknown." These are rational fears because change alters the environment that one knows and because an unfamiliar environment is often full of potential menace, though perhaps of opportunity as well. It makes sense to "freeze" temporarily, as a way of gaining time to learn more about one's new environment and adjust to it.
In an economic setting, the natural "freeze" reaction to increased uncertainty is to increase one's cash balance, to hoard in other words, and thus, for the businessman, to reduce investment. (Were it not for this reaction to uncertainty, an increase in uncertainty would stimulate rather than dampen investment. The reason is that uncertainty implies a widening in the range of possible outcomes of an investment decision, and because the investor has limited solvency and anyway his personal assets are shielded if he operates in the corporate form, his downside risk is truncated, but there is no limit on his profiting from the investment if it's a success.) Cash does not yield any return (except in a deflation, when the purchasing power of money increases, so that money grows in value without being invested), but it has value because of its liquidity. If you have an unexpected expense, you can pay it immediately rather than having to liquidate an asset, such as a house, which may take time, and in addition the asset may have to be sold at a distress price to raise the cash that you need to pay the expense.