Bryan Caplan  

Panic Puzzle

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Scratch Beginnings and ... Derivative Exchanges and Syste...

Last week was the most plausible example of a psychologically-driven financial panic that I've ever lived through. I have to think that most of the people who sold did so because they were scared by falling prices. Falling prices, in turn, scared people. At risk of sounding like a pop psychologist, the result was a scare spiral.

Admittedly, the fact that you're paranoid doesn't prove that "they" aren't after you. Maybe all this fear-driven selling is just bringing the market back to where it belongs. But I'm skeptical - I think last week was noise trading run amok.

In any case, suppose I'm right. What then should we think about Paulson, Bernanke, and Bush publicly freaking out in the weeks before the panic? What should we think about all the voices warning about "the end of the world"? While there's no way to know for sure, isn't it at least plausible that in the absence of this high-profile doom-saying, last week's panic would never have happened?

For the first time in my adult life, I'm wondering if FDR got something right. We definitely have more to fear than fear itself, but fear itself really can turn a problem into a disaster.

Questions: Am I on to something? Or does this line of thinking lead to the Dark Side?


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COMMENTS (20 to date)
Unit writes:

World governments have clearly unearthed the war-hatchet and I worry that when they get around to do the things they want to do, markets will have already recovered.

saifedean writes:

Here's an alternative hypothesis:

Markets were plunging not because of panic, but because they were headed to their true values, especially after the bail-out, which was bad news for any American company since it effectively means more taxes in the future to fund the bail-out.

The only thing that stopped the slide last week was the announcement by Paulson that the government will be investing in stocks. This led to a surge of buying which raised the prices a bit.

scott clark writes:

Noooooooooooo! Its better to see the supposed leadership panic, that lets everyone know they can't be trusted.
FDR could reassure people, but he reassured them by saying we've got you covered, you can trust me. and the clever ones knew that was a ruse and held on to their money, the rest gave over their allegiance and energy to the state, and thus gave more credence to the american strongman, dictatorial president.

Ryan writes:

I think you're partially correct by employing a psychological explaination of the huge downturn in the stock markets. But another aspect that I don't think is entirely trivial is that, on the margin, some traders had to sell assets that they did not really want to sell but had to in order to cover losses elsewhere. This sort of "forced selling" probably had an impact in propelling the market lower than what we may think to be the "true values".

Les writes:

It seems plausible that probably Paulson, possibly Bernanke, and almost certainly Bush, were as baffled as FDR was in the 1930's, but felt they had to appear resolute and in command for 3 reasons:

1) To try and stem any possible panic;

2) To protect their images of being in charge;

3) To avoid being blamed afterward for inaction or indecision.

So their actions may have been rational, even if ineffective or harmful to the economy.

James A. Donald writes:

Your thinking leads to the dark side.

My explanation is that suddenly a lot of credit default swaps had to be settled. People need to write checks or get cash for four hundred billion dollars or so. So they had to sell shares. In due course those who receive the cash will buy shares.

Gary Rogers writes:

You are definitely onto something. Instead of working behind the scenes to explain their plans and muster political support before announcing the bailout; Bush, Paulson and Bernanke used the doomsday strategy. This had the desired effect of forcing congress to pass the bailout legislation, but left a very divided populace. One side thinks the bailout is necessary because it is the only thing that stands between us in a 1930s style depression and the other side thinks the bailout will not work but we are headed for a depression simply because our government is in the hands of idiots. With one simple strategy, they convinced everyone that the economy is doomed.

A true leader would be pointing out that things are serious but even though growth has slowed, we have not yet had two quarters of negative growth so it is possible that we may not even have a recession. A leader would point out the differences between the contractionary monetary policy of the 1930s and the expansionary policies today and how that will unfreeze the financial markets eventually. A leader would be reassuring everyone that we are going to get through this whether we pass the proposed legislation or not. The proposed legislation is an attempt to work together as a country to speed up the process of healing financial markets, but not something on which the future of our economy depends. A leader would be pointing out the dangers of divisive strategies like protectionism, class warfare and political finger pointing that deepened the depression in the 1930s. A leader might use scare tactics, but only in private meetings where participants are sworn to secrecy for the purpose of preventing panic.

Actually, I think a leader should have a better understanding of economics and not propose the bailout in the first place. But, I may be asking too much when I add that expectation. Unfortunately, I see no leadership. Bush, Paulson and Bernanke created panic throughout the entire civilized world. Nancy Pelosi, Barny Frank and Chris Dodd are some of the most culpable in setting up this situation showed only petty political gamesmanship in trying to handle the consequences. Out of 535 legislators, there may be some leadership, but I certainly did not see any.

Here is what worries me in the future:

Lack of leadership means a failure to recognize that encouraging a person to overspend may not be doing them a favor. Government policies that encourage low down payment mortgages and students graduating with thousands of dollars of student loans have been one of the factors leading up to our current situation. I see no recognition of this problem which means it probably will not change any time soon.

Through lack of leadership we are going to see more government control of financial systems. It was bad legislation rather than lack of oversight that created the problem in the first place. More oversight has a greater chance of introducing additional bad legislation than solving any problems.

Through lack of leadership, congress continues to spend as though we have an infinite source of wealth. Additional new guarantees and the $700 billion transfer of questionable assets from the private sector to the public sector have significantly weakened the treasury. We do not need to make the same mistake we made in the 30's by trying to balance the budget in a depression, but there needs to be at least some common sense in government spending.

The congressional hearings with the executives of Leiman Brothers and AIG are class attacks charging the executives with taking their pay as the companies go down the drain. This may be popular, but it is not leadership. This is repeating a mistake made in the 1930's where the people who could have been the most help were excluded from the solution.

Lack of leadership in government has given congress only one tool to fight economic downturns, and that is economic stimulus to encourage consumer spending. Our current problem is that consumers have overspent and need to deleverage. A stimulus when deleveraging is called for can do more harm than good.

Matt C writes:

If you believe that worried talk from public officials caused the market to suffer a temporary burst of irrational panic, this is a great buying opportunity. You should be pleased, not dismayed. Buy buy buy.

If you believe we are going to suffer a lasting and painful correction mainly because Bernanke et al allowed the atmospheric concentration of empty platitudes to get too low, then yes, you have gone over to the Dark Side.

Jim writes:


Have any data?
Certainly fear was in there.


2 stocks I follow were driven way down by Execs dumping huge numbers of shares of their own company to meet Margin Calls.


A lot of fear in the banking sector. They seem to be afraid to loan people (or each other) money. Or maybe they are afraid they are or will be under capitalized.

RL writes:

Bryan,

If you're going to live your life by principles, "FDR got nothing right" is one of the safer principles to use...

The Cupboard Is Bare writes:

"In any case, suppose I'm right. What then should we think about Paulson, Bernanke, and Bush publicly freaking out in the weeks before the panic?"

It's just my opinion, but I think that they wanted to sufficiently frighten the public so that it would turn to the government for guidance and in turn support whatever course of action the government deemed necessary.

To a certain extent this strategy has backfired, as there are many people who are angry because their elected officials completely disregarded their wishes.

I suspect that after the election you will see many new faces on Capital Hill. However, I also believe that if the powers that be successfully complete their agenda, that they're not going to care.

lawrence writes:

The force is strong with you but master your emotions you must.

Less Antman writes:

Perhaps, Bryan, but a giant and generalized margin call on professional traders is a more likely explanation. Short term Treasuries rise during flights to safety, but fell several days last week. People don't sell short-term Treasuries to find something safer, since they think these are the safest investments in the world (they're not, but we're dealing with description, not prescription, right now). They sell them because they're liquid and the easiest way to raise cash that is immediately needed.

I saw a report on the London Banker site suggesting that a specific decision to demand more margin from their professional traders was made by J.P. Morgan Chase and Goldman Sachs at the start of the month, with October 13 the biggest deadline. That would make more sense (it would also suggest that the problem will be over in a few hours). See http://londonbanker.blogspot.com/2008/10/turbulence-and-trends.html?showComment=1223710140000#c3521599626172745343

Of course, if the crash continues past Monday, foolish panic becomes a far more plausible explanation. Until then, I'd say the only thing investors have to fear is ... wait, somebody might have said that before me.

Adam writes:

Amen to Gary Rogers' comment.

jb writes:

There is definitely a way to "work" the economy by keeping ignorant people reassured. For a while.

FDR had a war to get people's minds off of his economic activities. Without that war, I'm not sure that his 'keep the rubes distracted with make-work projects' would have continued to work for long.

So really, Bryan, you should ask yourself if the combination of 'fooling the people into complacency plus a bloody global war' is the right strategy, since they need to go hand-in-hand.

(My opinion, anyways)

caveat bettor writes:

I believe that hedge funds and investment banks are still highly leveraged. They have been massively deleveraging, but as their assets fall in value, their leverage creeps back up. And because they have posted these assets as collateral in order to leverage, they must sell these assets to meet margin requirements, which creates a vicious spiral downwards.

Panic selling may be also part of the equation, but not everyone is selling. I think there is some smart money buying out there, too. For example, Warren Buffett has put over $20 billion into a few deals in the last month.

The Snob writes:

The massive drop on Thursday afternoon after falling below 9000 struck me as a classic resistance-breaking behavior. People said "it can't go below 9000" so when it did it set off a rush to the exits. But then it broke 8000 and bounced back off the floor. That gave me the feeling that there's at least a temporary hard floor there.

One factor that seems different to me now than in crashes past is that exchange-traded funds are a much larger percentage of market volume. If you believe that retail mutual fund investors have a higher propensity for panic than institutional managers (I'd love to see a real study on this), then the much higher liquidity of ETFs is going to lead to proportionally increased volatility.

Anonymous writes:

Matt C wrote:

If you believe that worried talk from public officials caused the market to suffer a temporary burst of irrational panic, this is a great buying opportunity. You should be pleased, not dismayed. Buy buy buy.

If you believe we are going to suffer a lasting and painful correction mainly because Bernanke et al allowed the atmospheric concentration of empty platitudes to get too low, then yes, you have gone over to the Dark Side.

Huh! Does it mean you've gone over to the Dark Side if you believe there are multiple equilibria in a panic?

Isn't it obvious that there are?

Less Antman writes:

The Snob wrote:

One factor that seems different to me now than in crashes past is that exchange-traded funds are a much larger percentage of market volume. If you believe that retail mutual fund investors have a higher propensity for panic than institutional managers (I'd love to see a real study on this), then the much higher liquidity of ETFs is going to lead to proportionally increased volatility.

--------------------

I'm pretty sure ETFs would be a reason for the effect of retail investor panic to be smaller, not larger. When an investor sells shares in an open-end mutual fund, they are selling back to the mutual fund itself, and the fund is forced, whether it likes it or not, to sell some underlying investments to pay for the redemption. When an investor sells shares in a closed-end fund, such as an ETF, they are selling to another investor, but the underlying fund company is unaffected, and doesn't need to liquidate any underlying investments. That, in fact, is the very reason most emerging market mutual funds are closed-end funds: to eliminate the effect of panic selling by retail investors.

There is another reason to doubt that ETFs are part of the problem: since the ETF doesn't have to redeem small investors, a major discount would have resulted from panic selling, and ETF premiums/discounts were not out of the normal range last week.

I love your parenthetical "(I'd love to see a real study on this)", because I think you've hit on something: the idea that institutional investors are less emotional or subject to panic than retail investors is dubious at best.

JanissaryAustin writes:

Anecdotal data for the 'who's more panicky?' question: Eight out of ten acquaintances I've spoken to in the last week said they can't bring themselves to look at their stock/retirement portfolios. The only two who had actively managed their accounts were in lower income classes with much smaller retirement/stock portfolios...

Also, how many quadrillions in derivatives before we can start to panic?

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