Average Medieval times for humans... And everybody fears these fire-breathing, jewel-stealing sentient creatures. There is just one problem. Dragons on this world are sparrow-sized, and aren't very social creatures. (So I don't think they will form a massive dragon swarm anytime soon.) Due to their tiny size, they can't torch down cities and steal princesses and do other dragonish stuff. What can a lone tiny sentient dragon have as weapons to strike as much fear as the typical Smaug-sized one? Being both poisonous and venomous is an idea.
Cities in the Middle Ages were flammable. Like, really flammable. London suffered from two devastating fires and several smaller ones before the Great Fire of 1666 that destroyed most of the inner city. Amsterdam suffered two massive fires in 1421 and 1452, the latter of which destroyed three-quarters of the city. Lubeck in Germany burned to the ground three times in the space of 120 years.
A dragon doesn't need to be dragon-sized in order to burn a medieval city to the ground. In fact, a sparrow-sized dragon would be able to flit around starting fires potentially without being seen, and definitely without being caught, unless someone nearby happens to have a (non-flammable) net or prodigious archery skills. No shotguns in the Middle Ages!
Once those initial fires grow and combine into larger fires, it's already too late for a medieval society to do anything about it. Anything that's not made of stone, or sufficiently protected by firebreaks, is going to burn. Your house. The granary. The cathedral. Everything.
So when someone in a medieval society sees a dragon flitting into town, they panic, because that means half the city is about to catch fire.
just to add to the other answers: Tiny dragons setting an entire city on fire not only is realistic, we have something similar in our world too:
Let me introduce you to the Australian Firehawk Raptor
This little sh*t not only does start fires to force its prey to come out of hiding, they were HELPING spread the Australian bush fires.
So just replace feathers for scales, make them do their thing at night and now you have a little devil who may kill you and your family while you sleep and its so small that there isn't really much you can do to stop them
I want you to meet: The Gimpy Dragon.
Like the Gimpy tree this tiny dragon grows hairs with neurotoxins in it that cause extreme pain for a few hours to days and then will keep hurting you to a lesser extend for months to years. And if you look at one of the names of this tree you can take a guess how much pain that is: the suicide tree.
Unlike the Gimpy tree these tiny dragons can get pissed and fly into your face. Since they arent social dragons they are likely very territorial, so one sparrow-sized dragon that will leave trails of neurotoxin hairs near its nesting area for unwary people to brush against or step on that will get angry at people that get too close to its nests and fly against you and start fires for good measure? That is some terror right there in any time period. I wouldnt even trust a Hazmat suit when dealing with such critters.
Of course they can burn down cities. Cities are made of wood. All it takes is one puff of flame and everything can go up in smoke. There is some reason to believe that Mrs. O'Leary's cow did not cause the Great Chicago Fire, but that springs from evidence not from any inherent implausibility in a kicked-over lantern causing all that death and destruction.
And as they are so small, they can wriggle anywhere to set their fires.
So basically you have an intelligent being that can kill hundreds of people and leave thousands of people destitute. If it targets granaries, it can ensure that everyone starves.
The downside of their size is that if they actually want to weaponize it, they have to go and talk with people -- swooping in won't cut it -- and they may be vulnerable then.
Are psychic effects an option? You could make the tiny little guys have a cosmic-horror-style soul-piercing gaze that brings forth the darkest, most twisted fears of their targets. Or mind-control and a twisted tendency to play with it's victims by making them kill their families or something.
Alternatively, they might breathe a hallucinogenic gas that did something similar. (See Batman's Scarecrow). Poison-gas breathing dragons are more of a thing in real-world mythology than our standard fantasy canon would let on.
Finally, they might do some horrifying, insect-like skin penetration. Fly down someone's throat and burst out of their gut like a xenomorph? Lay eggs in your skin?
It is a fatal mistake to think that the bigger the organisms the more dangerous they are. It is actually quite the opposite, especially when organisms are very small or intelligent.
Consider bacteria or viruses that we can't get rid of. Consider most pests, such as rats or ticks.
The best we can do (and that is 21th century!) is limit them in a particular area for a while.
Now, dragons would be quite dangerous on their own, due to their small size, but add intelligence and they would quite literally own the humans. If they felt like it.
Assassinations (either by poisonous bites, or, if they aren't poisonous, by carrying it), setting towns on fire as described in many answers, spying so they learn whatever humans are trying to organise to oppose them, herding animals into stampedes, for trampling or eating the corn, you name it and intelligent species will be the better at it the smaller and nimbler they are, compared to opposition.
Humanity's only hope is in the fact the creatures are not very social and there is some limit to the amount of control a small group of them can wield. Still, a city would be at mercy of a single one. Or burn down. Or have a famine. Or have an invasion of raiders at the precise time when it can't be repelled. Or have their well poisoned. The possibilities are endless. Fungal infections, breeding vermin in hiding places,... I haven't even started.
Seriously, I often have thought that the only reason ants don't rule the world is because they haven't got the intelligence for that. Yet.
People are pretty terrified of:
Which, I think, proves that size doesn't matter. You have the size of the dragon in your head as part of what makes it terrifying, but those people don't (although they might have stories of huge dragons like we would of huge tarantulas). You need to think of it like a scorpion or tarantula and maybe have a scene early on where someone is cornered by one, surprised by one dropping on them or coming on them from behind, maybe latching on to their neck and when they try to pull it off there are spines that cut their hands and cause searing pain. You need to give the reader the ability to feel the fear. The hair raising on their neck when they hear the sound of their wings.
You might want to read real life accounts of attacks by small things. There's a (fictional) story by Dahl of a man that wakes up with a krait on his stomach under his bedcovers that might be of use.
They spit a napalm-like substance (or Greek fire, if you prefer.) Sticky, somewhat gelatinous and burning at relatively high temperatures of 800 degrees Celsius or higher. Even small amounts could cause serious injury or death if it landed on the wrong part of the body. If it got onto a flammable material like wood, the fire could quickly get out of control.
If you wanted to take it to another level, have the substance automatically react with air so that even dousing it in water won't completely extinguish it. As soon as it is exposed to sufficient oxygen, it starts burning again.
It's as if you didn't spend any time in a tavern, lad. Otherwise, you would have heard plenty of stories by minstrels and all kind of travellers about all the nasty things dragons can do. They may seem small and harmless, but they will grow . There are also those that . Do you remember the Great Fire of Rome? That was caused by a dragon. The Sinking of Dongfang zhi Xing? That was also made by a dragon, angered because a merchant traveling there didn't give it a emerald it wanted. Not to mention that those evil dragons will grow to a hundred its size in order to eat you.
Just a couple of nights ago, a guy from Elbonia explained us how his second cousin once removed was once in a ship with another passenger, whose aunt was the maid of the governor of Belgrade at the time when an elephant sized dragon stole them the royal jewels, and left after setting the palace on fire.
You don't need your dragons to be big, evil, able to torch cities or steal princesses. Only that your widely believed folktales says so. Just hearsay will greatly exaggerate many trivial acts. But of course, your dragons being sentient, they could actually the source of many of those stories, as a way to protect themselves with such reputation (e.g. everyone fears Pirate Roberts).
There is a story told in several different settings of armies catching birds from cities they besiege and attaching burning materials to the birds and setting them loose to go back to their homes in the cities and set fire to the thatched roofs of those homes.
I don't know if that was ever tried, but ancient and medieval buildings and communities containing them were so vulnerable to fire that different people thought of that strategy and told stories about it that I remember.
I have lived in Perkasie, Pennsylvania since 2015. Two 12-year-old boys playing with matches and paper started a few tiny fires that grew and spread and burned down a few blocks of the Perkasie business district in the Great Perkasie Fire of June 26, 1988, causing millions of dollars in damage. It was considered a miracle that nobody was killed by the fire.
Of course modern buildings usually have a lot more stone, brick, and concrete than most medieval buildings did, and Perkasie had a much better fire department than a medieval city or village, but many buildings were still consumed by the flames.
So small flying (?) dragons that can create small fires would still be feared by medievla people.
What if the small flying (?) dragons are venomous like adders or cobras or asps? Medieval people were afraid of the local venomous snakes. And they would be even more afraid if the local venomous snake had wings and could fly and might fly over and land right next to you, so that you might not notice them and step on them and get bitten.
If a large percentage of the people bitten by tiny flying dragons died, medieval people would always be looking around in fear to spot tiny flying dragons approaching.
A lot of modern people are afraid of flying stinging insects, even people who aren't very sensitive to their stings and aren't in much danger of dying from a sting. If a higher percentage of flying dragon bites were fatal, they would be feared a lot more than flying stinging insects.
A lot of people react with extreme fear to bats flying around, even though bats are mostly harmless. I expect those people would react with much greater fear to tiny dragons flying around if those dragons could spit fire or had venomous bites.
Hummingbird-like dragonets would be impossible to catch or stop. As soon as you spot one it has surrounded you with a ring of dozens of small (and rapidly-growing) fires and flitted away.
They can perch on arrows mid-air, zip through the narrowest opening in the blink of an eye, burn the clothes off your back as you try to swat them.
Just stay still and try not to aggravate them.
The Dragons Hibernate in Unlikely Places and are Hard to Find
The little buggers are problematic enough to a man in broad daylight, but they will go to sleep for variable times in many hiding spots. They fly for a time, undetected, then go to sleep in another. This means that even in civilized places, you may find yourself face-to-face with something that can melt your face off in seconds, that you can't reliably find, you can't easily fight.
Latrines, granaries, temples, boots left open, library shelves, underneath bread ovens, wherever would be the least convenient place to find a fire-breathing thing suddenly fly out, screeching and clawing for your eyes, that's where dragons go. It's hard for a person to sleep well when the whole of the environment around them could suddenly have a terror in it, and tomorrow night there will be a different set of places.
Make the beasts look like spiders.
Source for the image above: https://www.reddit.com/r/Sculpture/comments/eqtld5/self_dragonspider_dont_ask_how_it_happened/
I would totally freak out and scream like a little child if I saw something like that.
Make it look like a [REDACTED] ROACH instead, and I swear that if one ever made it into my house, I would move OVERSEAS.
AUGH AUGH AUGH ANKLE BITERS. Personally, i jump and attempt to swat at anything that starts biting my ankles thanks to an unfortunate encounter with a cat a few year prior of this writing, and i would be pretty terrified of something that could set my ankles and also me on fire. not to mention that small dragons can usually go real fast and there would be close to no way to shoot them down.
Think electric eels. Now give them wings and make them hummingbird size and highly aggressive--if it sees/smells/hears you, it zips over and kills or stuns you with the shock. Then it shocks anyone it encounters while escaping. Sure, throw in poison and fire if it fits the plot, but if I had evolved in a world with fast, flying creatures that could zap me to death or unconsciousness, I'd be instinctively terrified if I locked eyes with one.
Dragons are telepathic relays. If a dragon is near a group of humans then some of those humans will get random out-of-context fragments of what the others are thinking.
This is quite scary, because you never know when some thought you very much want to keep quiet is going to be broadcast to someone else, and there are lots of stories told about how an illicit thought at the wrong time led to disaster, possibly including lynching.
For instance, Joe Bloggs claimed that he got a thought from Pete Smith about murdering children, and Pete was subsequently lynched. Shortly after he stopped kicking several people got a thought from Joe about how he hoped they never found out it was a lie, so Joe got lynched too.
Adapted from current headlines:
Dragons are like locusts. They are usually solitary, but due to a mysterious mechanism (cough meddling wizards cough, maybe) every so often they swarm. To densities of up to 80 million per square kilometer. Sure, a single dragon can't burn down the village, but when there are literally taking up more space than there is land,
random puffs of fire will quickly burn down anything...
Of course, the crops don't fare well either.
Make them mind-controlling parasites. The book series (not the movie series) of How to Train Your Dragon, by Cressida Cowell, has distinct subspecies of dragons that fall under the 'nanodragon' category. The vast majority of naondragons are based off insects.
These dragons would be the same way, but based off parasitic wasps (oh, and Xenomorphs). One of these sparrow-wasps will stealthily fly around until it finds what seems like a good target (isolated, not paying attention, preferably an outcast so no one realizes what happened to them) and then it will fly up to the back of their head, jab their stinger in, and implant an egg.
The egg will soon hatch, unleashing a worm. This worm will crawl in through the hole where the spinal cord goes in the skull to connect to the brain, and then it will pull an NPV (nucleopolyhedrosis virus) and liquefy itself, seeping into and taking control of the host's very brain.
Eventually this draconic infection will cause the human to gain enhanced strength, speed, claws, and fangs, which it will use to bite and spread the infection. Sort of a cross between a 28 Days Later zombie and a vampire. However, the first victim will become like Victor Validus in Ben 10: Alien Swarm: like the regular 'zombies,' but capable of spawning more sparrow-wasps, let's say from the mouth (Cressida Cowell's dragons have fire-holes, and it's hard to question the terror of someone opening their mouth wide, revealing a hole in the back of their throat that a sparrow-sized dragon-wasp of death emerges from).
Just one of these things will cause terror and chaos, so no swarm or even grouping required; just one sparrow-sized dragon-wasp and a blissfully unaware human being.
You could use learned behavior to make something scary, even without giving it weapons.
For example, what if all the forest animals are afraid of small dragons? They start to flee or hide when they see one, or fall silent when one is near. This would make their presence ominous. Humans would copy this behavior.
But if it's all bark and no bite, people would eventually see through it. So I would suggest that regardless, they have a weapon of sorts. But it doesn't have to be a big one.
The same reason why people are afraid of non-venomous garden snakes: the dragons fed on our early ancestors!!! Think of it, when our mouse-sized ancestors poked their noses out of their dens, the venomous dragons were waiting for them. Since the dragons preyed on our early ancestors, the fear has become so deeply embedded in our bodies, that we are still afraid of them even though they don't eat us anymore!!! Also, consider the venom factor. People are scared of venomous creatures because the venom can kill them. Apparently, the dragon's venom can kill a person with a single bite, which is why people are afraid of them.