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Hypnosis is a real phenomenon, and even animals can be hypnotized. But what hypnotism is, exactly, remains unclear.
In a remarkable experiment reported in the New York Times , subjects were given the post-hypnotic suggestion that they would see words that would appear incomprehensible as if in a foreign language. They were then put in a brain scanner and asked to perform the "Stroop task" in which one reads aloud the color of words but not the text.
Here is an example Stroop task shown in English and Dutch.
When the words are in a foreign language, the task is easy. When they are in your native language, it is almost impossible to do correctly (try it!) due to an "interference effect" that causes the meaning of the words to take priority over their visual color.
However with the post-hypnotic suggestion, subjects were able to do this task effortlessly. Not only that, but the fMRI brain scan revealed that the brain region responsible for language did not become activated. So not only did the words "seem" to the subject to be in a foreign language, the brain actually processed them as if they were. This experiment may be the first solid evidence that hypnosis is a real neurological phenomenon.
But what kind of phenomenon is it? This is where the controversy begins.
Hypnosis is generally regarded as an altered state of consciousness, a broad category that includes meditative states, the "flow" state, psychedelic drug-induced states, and psychosis. But since consciousness isn't understood, alterations to it aren't very well understood either.
More specifically, hypnosis is a state of extreme "suggestibility," a phenomenon that includes the placebo effect, advertising, and religious cults, but may also include any context-specific behavior. If a stranger at a train station asks you to take off your clothes, you would call the police. But if a stranger wearing a white coat at a hospital makes the same request, you would comply naturally. Have you been hypnotized?
Hypnotism may simply be the artful manipulation of attention, language, and context to establish an alternate set of temporary beliefs, which then influence perception and behavior.
The hypnotic induction procedure generally involves three components: direction of attention, unusual use of language, and tests. The direction of attention determines what will or will not enter perceptual awareness. The unusual use of language can divide consciousness, so that suggestions are made indirectly while reasoning and skepticism is distracted. The tests are tasks used to create the illusion that the subject has surrendered control to the hypnotist, thereby causing the subject to surrender more control. For example the hypnotist may say your eyelids feel heavy, so that when you feel it, you believe that you are now hypnotized, which causes you to become more hypnotized.
Many trance levels have been identified. In some models, there are more than 30 distinct "trance depths" from lightly suggestible to the ability to forget words, not see an object, see something change color, not notice pain, or "fall asleep" on command. While a stage hypnotist can persuade someone to do something embarrassing, it is generally understood that people will not act against their own value system.
Hypnotic effects do not always require a formal induction procedure. Milton Erickson, perhaps the most effective hypnotherapist who ever lived , was once treating a boy who came i to the hospital E-R needing stitches on his forehead. Rather than using anesthesia, Erickson explained to the boy how he would sew up the wound if he were to do it. He explained what he would do in great detail, gesturing around the boy's head and going through the motions. The boy became impatient and asked him when he was going to start. Erickson replied that he had already finished.
 New York Times article on hypnosis and brain scanning (2005): This Is Your Brain Under Hypnosis
 Wikipedia on Milton Erickson, master hypnotist: Milton H. Erickson