Bryan Caplan  

How to Scare a Kid

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What's the best way to scare a kid?  You wouldn't just put on an ugly mask and chase him.  He might think it was a big joke and start laughing.  To be confident of a successful scare, you'd lay some groundwork first.  A week or two before the big event, you'd start warning him about a local monster, show him some pictures of the beast, and tell him some tales of its evil deeds.  You'd build up to the big day with gory descriptions and vague warnings.  That way, when you put on the mask and scream, you know you'll be giving the poor kid the scare of his life.

Needless to say, Scaring kids is wrong and you shouldn't do it!   I bring this up to illustrate a point: If you think that the recent stock market crash was a psychologically-fueled "panic," it is quite likely that Paulson-Bernanke's pre-crash fear-mongering was the crucial factor that sent investors over the edge.  If P-B had gotten hysterical without warning, the world might have just laughed at them - and expected them to retire to "spend more time with their families."  Instead, they spent weeks building up the boogie man, giving us gory descriptions and vague warnings.  Psychologically speaking, this seems like a great way to put the world on the edge of its seat.  At this point, all it took to get the market to flee in terror was an ugly 7% decline.

I'm not sure that this story is correct.  But these days, it's pretty hard to dismiss psychological theories of stock market movements.  And if you take psychological stories of financial markets seriously, it is quite plausible that Paulson and Bernanke's Tales from the Crypt wound up creating the massive crash they were trying to avoid.  Doh!


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COMMENTS (22 to date)
J P writes:

40 years from now, when the full extent of the mishandling of this whole crisis has been felt, the primary emotion of your then adult children will be terror.

What is the best way to scare a kid? Put a massive lien on his inheritance before he knows how to work.

V writes:

I think you mean the Paulson-Bernanke-Cowen fear mongering.

E. Barandiaran writes:

Bryan,
I've been trying to understand what has been going on in Iceland (they're close to an agreement with the IMF). I suspect that there were some people trying to scare all foreigners dealing with Iceland's three banks (someone has already accused Gordon Brown, the UK's PM, but the evidence is weak). I let you know when I finish my review.

jb writes:

In my personal experience, the best way to scare a kid is to pretend to be a mad scientist in a haunted house, and ask them if you can borrow their brains for experiments.

I am told that after leaving my exhibit, the kids were really, really freaked out, far more so than by the werewolves and vampires before them. And I wasn't even trying that hard!

But "pulling a Paulson" definitely has some merit :)

Michael Kolczynski writes:

I just got into trading last year. By last month, I had doubled my initial investment. I even managed to make big scores after the peak in late 2007. Since then I lost almost 50%, so I'm almost back to where I started (I'm a little ahead).

I laughed hysterically as the market plummeted, even though I was losing globs of money in minutes. I certainly care about the money I lost, I would be better off if I had seen the panic and sold. I laughed because the valuation of my portfolio is a constantly fluctuating number, based off what the last person has paid for identical items. I laughed because it's all happening in such a short period of time, the outrage and panic is so very hyperbolic, yet the pain is nothing like the horrors of starvation seen in Mao's China, or any other longer, more severe "failures."

Yes, a market crash is easily caused by fear. All you have to remember is that market cap isn't the real valuation, it's just the # of available shares times the LAST sale. Even if millions of small investors aren't scared, a few large hedge-fund managers try to convert stocks to cash when no one is particularly bullish and you get a deflation of valuation of the portfolio. But since the market cap is based on the last trade, you can't just say "this is what it would cost to buy the company," because you have no reason to expect a majority of the shares would be sold for that price.

I'm not making any decisions until volatility subsides, so what's my portfolio valuation? What's the value of a portfolio on weekends or holidays when there's no trading?

scott clark writes:

So could they just get on TV and say it was all a joke, a hoax to get everyone ready for Halloween? "We were kidding, there is no economy monster, the investment banks were just playing along."

Just as with scareing a kid, they don't fully believe you even when you take it all back.

j writes:

You mean the subprime issue was marginal? That all that complex leveraging was unimportant? Were P_B's soothing words (before begging for 700 B) that caused the world to panic and run on Lehman?

8 writes:

And now...Deep Thoughts...

It's not good to let any kid near a container that has a skull and crossbones on it, because there might be a skeleton costume inside and the kid could put it on and really scare you.

Chastity Trantham writes:

The psychologically fueled panic concept is an interesting and innovative thought to why some economic panics do occur. Many times throughout history people’s perceptions of events, whether skewed by media and politics or not, have caused an event to occur or become more drastic. For instance, runs on a bank caused the bank’s failure which is serendipitous because the fear of the bank’s failure caused the run on the bank to occur in the first place. The truth is simple that people in general become panicked for really no reason at all but our panic causes a reason for us to become panicked.
Caplan also makes a good point, that the previous upset provided by Paulsen and Bernanke could have caused the reaction to the only seven percent drop to be more drastically recognized. I personally agree with Caplan that if fear had not been built up for weeks that the reaction would have been less severe if even existent. I believe an event like this also occurred concerning the gas crisis recently. Until people began to run to the gas station to beat the high prices that were expected, there was in my opinion no danger for a rise in gas prices. However, when people began to run on the gas stations causing them to run out of gas it essentially in my opinion caused the gas prices to increase.
While there are other lurking variables that I believe do contribute to many of these economic panics, I certainly feel that the psychologically-fueled panic concept is something to be respected. However, this concept is underestimated. I feel that we as a nation could prevent some panics, if we would realize that we in fact can cause the object of our fears. I also believe that if we could take a step back to realize that when we panic it hurts us in the long run, it would help us as citizens to improve many and even go as far as to prevent some economic situations. A roman statesman, Appius Cluadius said “Each man is the architect of his own fate”, while I understand we cannot as individuals influence the entire market, I think that our perceptions do influence the outcome of many economic situations.

dm writes:

Although it IS a sort of 'deep thoughts' post, I didn't feel that BC gave a lot of context for his evaluation that maybe P-B had a hand in their own self-fulfilling market downturn. For instance, if it's possible to talk down the market, even for a few months, is it possible to talk down the economy? For how long? I'm increasingly interested in whether the market is or isn't fully coupled to the economy. I don't think that is actually as easy to answer as it sounds.

Michael's point about volatility is somewhat well taken by me too... in that I don't think we know how to make a valuation of companies' future profits when there is no market. How long is that state of affairs allowed to be decoupled from actual profitability? And, can company profits be 'talked down'? For how long?

Transparency will be achieved, whether by force or by the market itself. The only way to determine cashflows is to be allowed to look in the box.

Gary Rogers writes:

If you want to get a good laugh, all you have to do is tell a Democrat that the economy is fundamentally sound.

Cyberike writes:

To date, people in my area have still been able to buy houses, and finance cars. None of the people I know have been affected at all by the banking "crisis", and I bank at WM. My home loan is through WM. Did anyone reading this actually feel personally any of the fallout from the bank crisis?

It seems like a few weeks ago the common theme was to let the banks fail. In my opinion, that was what scared P & B so much. There had to be a sense of large scale, imminent doom in order to get the 700B dollar bailout plan passed. I am not saying this was a scam, because banks actually were in crisis. What this has to do with normal people, though, I have no idea.

Marcus writes:

I believe that market commentators suggesting such explanations are, in effect, admitting they don't understand it.

That's OK, the whole premise of why central planning can't work is because central planners don't have available to them all the information they need to make good decisions. Your inability to explain the market is simply a manifestation of that fact.

El Presidente writes:

Right. Shoot the messenger. If that's an accurate description of what they were doing, why were they careful not to let everybody know which banks were failing? "See no evil, hear no evil, speak no evil" only ensures that we are blind, deaf and dumb when evil appears.I think they were circumspect and only began sounding the alarm when things had gone out of control.

Go ride your local public transit for a few weeks and tell me there isn't a real problem with our economy. My guess is you won't be able to find a seat. I have the special experience of having ridden before, during, and after the crash and I can tell you with certainty that transit began to become congested before the crash. Exhaustion of disposable income caused this to occur and it won't be fixed until there is enough income to cover the basics again.

mitch writes:

one of your best.

Dr. T writes:

"It is quite plausible that Paulson and Bernanke's Tales from the Crypt wound up creating the massive crash they were trying to avoid."

I don't believe they were trying to avoid a stock market crash. I believe they were so focused on saving the large Wall Street financial institutions that they failed to recognize the potentially disastrous consequences of their actions.

But, what the heck, we taxpayers are thrilled about sending trillions of dollars to the IRS so Paulson can oversee the biggest central government financial experiment in history. (I keep seeing the scene from the James Bond movie Thunderball where Blofeld is presiding over a meeting of SPECTRE executives.)

Lemizeraq writes:

1. Bernanke, Paulson et al did not cause the crisis. The management teams for Bear Stearns, Lehman Brothers, Fannie Mae et al were the ones.

2. Without the speeches and warnings that they made prior to the pushing through the bailout plan, it would not have succeeded. And we would be on the very brink of a Greater Depression.

3. To close their mouths and pretend life is carrying as it is would be causing disservice and a clear failure of their roles as public servants.

4. By clearly warning the public and other government that there is systemic failure in the credit market, it is the crucial first step to rectifying and repairing the financial markets and later, the type of regulations and oversight needed.

So, I don't agree with your thoughts that they contributed to the crisis.

Far from it, if it doesn't turn out to be another Great Depression, both of them would have earned their salaries and then some.

ALYSSA writes:

i think that that plan is awesome && halarious;;


i LOVE it

michael a writes:

If you tell people it's the new Fed Chairman has the distinction of being expert at the Great Depression, you are telegraphing that you should expect it.

Fred writes:

Buying and selling is human behavior.

Psychology is defined as the science of human behavior. All behavior is therefore psychological, even eating lunch.

So panics and bubbles and so on are always psychological, even in the good times. Mainly it's a balance of greed vs fear.

The only exception is programmed trading and other computerized marketing. Then it's computer science, not psychology.

Joe writes:

El Presidente makes a good point. All of the Fed's actions over the last 14 months of this "credit crisis" have worked to deprive the market of information. The TAF allowed troubled banks to borrow from the Fed anonymously and therefore the market was not able to differentiate between the good banks and the bad banks. That is why the Paulson/Bernanke scare show worked so well. In that information vacuum, investors had to assume that ALL banks were in trouble even if that was demonstrably untrue (someone else's remarks about how the "credit crunch" hasn't affected his or his neighbors real lives).

To El Presidente's comments about the economy, there is no doubt that a recession was in the offing and things were getting worse, but it is the actions of the Fed that have prolonged the agony. And now the scaremongering has turned a routine recession into something that is likely to be much worse. Business activity came to a halt while everyone looked to DC for a solution.

The economy is suffering from a panic induced by government intervention. Part of that intervention was the scare tactics of P/B and it did have an effect, but it wouldn't have been as effective without the previous interventions (TAF, TSLF and all the other alphabet soup programs).

Steve writes:

El President,

Could it be that the fear of our worsening environment is leading people to ride public transportation? I'm not saying either theory is correct, just that your's is a bit disingenuous in that there are a plethora of reasons.

I ride, and have so since moving to the city I currently live, public transportation to get to work and do ~80% of my non-work intercity travel and have not noticed a large shift in ridership, perhaps 10% at most. Since I moved here though there has been much talk of people shifting to public transportation due to rising fuel costs and a sense of environmental do-goodery (ps I love that word.)

Of course, I also agree that in theory people concerned about their pocket book and may start looking towards public transportation as a way to save money.

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