The Fear Factor

Not since the Great Depression have Wall Street and Main Street been so gripped in fear. The lives of those who lived through the Great Depression in the 1930s were forever changed. Only two generations of almost unbroken prosperity since the 1960s have allowed us to shake the fear of loss created by the pain of the Great Depression. Fear and despair have returned. This is a book about the fear that drives troubled economies. I also explore how fear is manipulated, in politics and in financial markets, to benefit hundreds but cost billions.

Fear is an essential animal emotion. Its triggers, and the associated symptoms of anxiety or aggression fear can cause, have evolved to serve a number of very important purposes, and have served us well.

Life is uncertain by its very nature. In many ways, it is becoming less and less certain all the time. Our economic life is amazingly more complicated than what it was just a century or even half a century ago. Each of these complications brings not only more that can go right but also more that can go wrong. With progress, our economic well-being has been most enhanced while our economic security is most diminished.

Humans are by nature risk-averse. This is a simple consequence of the way we derive pleasure, and is well explained by economic theories that allow us to model human economic satisfaction and happiness.

On the supply side of loanable funds, we must identify the factors that differentiate lenders from borrowers. Contrary to borrowers, lenders are willing to sacrifice consumption today for even greater consumption tomorrow. They make this intertemporal exchange for a number of reasons.

International flows of capital have increased dramatically in recent years. This dramatic expansion of international trade in securities is a verification of globalization. It also creates a new investment landscape that has created both greater liquidity and some substantial new risks.

The utility curve readily tells us something about risk. It shows us why we value economic security and why any risk to our economic security creates discomfort. We will also see why declines in income from a market meltdown can breed fear and result in even greater subsequent declines.

We have now assembled the tools that will allow us to see the fear premium explicitly.

Fear, a measure of our tolerance for and reaction to risk or danger, has a demographic dimension as well as a wealth dimension. Our economic security, income, wealth, and human capital all change throughout our lifetimes. In this cycle of life, we also gain knowledge, wisdom, and experiences that can guide us when faced with financial threats. This life cycle has a number of interesting aspects.

Before I describe the economic approach to decision making in risky circumstances, let me offer some truth in advertising. It would not be unfair to conclude by now that most individuals do not behave as homo economicus, that uber-rational decision making fiction employed by economists to permit us to use the tools of rationality to analyze markets and human behavior. A simple example will demonstrate this.

One might surmise that, like matter, risk is inherent and cannot be created or destroyed. However, the choices of our corporate decision makers can actually amplify risk, while shareholders, as the residual claimant, are often left holding the bag.

Before the subprime crisis, mortgage markets had been operating efficiently for generations. Originally facilitated by local banks, mortgage societies, and savings and loans, these markets matched long-term and nicely collateralized borrowers with lenders that were equally interested in long-term lending. Risk was low because the approximately 60% of households who purchased homes strived toward and prized this American dream. Times have changed.

We entrust to others the task of ensuring that our corporations are well run, our markets well regulated, and our assets kept safe. We cannot always ensure that the agents we hire will actually perform this duty. In an environment with imperfect information, many problems can arise that will confound our trust.

We all aspire to “invest” our hard earned savings into financial markets that offer a return in excess of the small but risk-free return on Treasury bonds. With a typical inflation rate of 3%, bonds earning less than 3% do not even keep pace with inflation. They certainly do not build the nest egg we all require for a comfortable and, hopefully, extended retirement. What portion of our savings is truly invested, though, and what is merely rolling the dice?

We can use the results gleaned from the capital allocation line developed earlier to explore what happens as general market risk increases. To recall, the capital allocation line is a line drawn from the risk-free interest rate to a point on the frontier of the best combinations of return and risk in the marketplace, as shown in Figure 14.1.

We recognize that markets have two personalities. One is of the rational and careful analyst, researching the fundamental ability of a firm to generate future earnings, and establishing a best match between risk and return in the marketplace and their own tolerance for risk. The other personality is bipolar, carried to new emotional heights when the market is optimistic, and sinking to deep emotional lows when the market mood turns ugly.

There is a clear link between fear, panic, and economic crises, as subsequent chapters will document. But what is the true cost of fear?

Panics seem as old as markets themselves. Over the last 200 years, the United States and Great Britain experienced a dozen severe panics: in 1819, 1825, 1837, 1857, 1873, 1893, 1901, 1907, 1929, 1987, the Asian Contagion of 1997, and 2007–2008. While each of these arose from a different calamity, they share some important characteristics. Each provoked a fear that brought the market to its knees. It is instructive to understand the common dynamics of each of these crises. Clearly, our economic leaders are now doing just that. Perhaps so should we.

Art Deco, construction of the Empire State Building, F. Scott Fitzgerald, Jazz, Babe Ruth, Ernest Hemingway, Charles Lindbergh, women’s suffrage, speakeasies, and the lost generation — these are things that defined the 1920s. A huge financial capital appreciation, popularization of the automobile, movies and radio, design of the DC-3 aircraft, and the wholesale creation of retail investment by the masses also characterized what we affectionately call the Roaring Twenties. This wild and revolutionary era came to a grinding halt on Black Tuesday, October 29, 1929.

Anyone alive during the onset of the Great Depression and its aftermath was forever changed by its collective pain. This was a defining era for more than a generation. The lessons learned are all but forgotten now. The parallels between now and then has renewed interest in the Great Depression era.

As economies unwound around the globe, the British economist John Maynard Keynes was developing an explanation of consumer spending that was spot on for the era. His insights were both timely and profound, and are even experiencing a resurgence given the strong parallels between the Great Crash of 1929 and the Great Crash II of 2008, and between the Great Depression and our current Global Financial Meltdown.

What is it that causes the masses of investors to panic and run for the doors? And who manages to lead the charge?

World financial markets also went through a gut-wrenching financial decline in October of 1987. Sometimes called Black Monday, stocks began to trade steeply downward, first in Asian markets, then in Europe and Africa, and finally in the Americas. When trading was over at the end of that day, New Zealand’s market fell by almost 60%; Australia’s and Hong Kong’s fell off by more than 40%, and markets in Europe, Canada, and the United States were down by between 20% and 35%. The drop in the Dow Jones Industrial Average at 22.6%, represents the largest plunge in its history. Some argue that it was technology that led the markets down.

Risk assessment is a highly technical problem. If each bond investor was to try to estimate the downside risk of each asset under consideration, it would be likely that few investors would be qualified to buy bonds or other risk bearing fixed income securities. If such were the case, those issuing the bonds would have few buyers, and would then have to offer a commensurately higher interest rate to attract sufficient interest and raise sufficient capital. With such uncertainty and such an advantage to most skilled analyses, it would be smart for the bond issuers or investment houses marketing the bond issues to hire a risk-assessment agent to analyze the proposed security and give it a letter grade that would signal the level of risk to the marketplace. This is the job of the ratings agencies.

There is one thing that has become most apparent from the Global Financial Meltdown of 2008. We must certainly remedy the problem of regulators that are underpaid, understaffed, overworked, or are a bit too cozy with the institutions they are asked to regulate on our behalf.

The Global Financial Meltdown is also a meltdown in business ethics. How could this be? And what can we do about it?

It is somewhat ironic that we associate the capitalist model with financial capital and Wall Street. The domination of Wall Street is a relatively recent economic phenomenon.

The media is the conduit that allows us to create order in an increasingly complex civilization. It seeks out the information it believes we need to know and processes that information so that it is most accessible and relevant to us. Sometimes, though, in an effort to compete, it substitutes entertainment under the guise of information. Unfortunately, fear catches our attention better than almost any other emotion. The cultivation of fear allows the media to sell advertising so that it can remain competitive.

President Franklin Delano Roosevelt of often slightly misquoted as saying “There is nothing to fear but fear itself.” But a dash of fear sure makes leadership easier. There is an advantage to fear, from a political perspective. It makes for a more compliant citizenry.

while fear from a misled populace has taken a bad turn and created a downward spiral, merely soothing the fear at this point will not be sufficient to return us to better days. Why not?

When the global economy last faced the fears of a financial meltdown, it responded in the way that humans typically respond to fear. It blamed other countries and imposed trade barriers. Countries adopted Marxism, Fascism, and Totalitarianism in frustration with prevailing political systems. Capitalism was rescued only by the promise of Keynes and President Roosevelt that the economy could be reformed, albeit at a cost of much more government control. This contract with capitalism, through government spending and regulation, was unbroken until the deregulations that began when President Reagan unwound much of the New Deal policies.

if we acknowledge the importance of investor confidence, and can deal with market failures and fear head-on, we can prevent the Global Financial Meltdown from reoccurring. To do so will necessitate some changes that can reduce market fear.

Humans are hardwired to protect our economic security and crave order. Any threat to our economic security is considered risky, and as humans we are, by our very nature, averse to risk. As the world becomes increasingly uncertain, there is greater occasion to threaten our economic security and fan our fears. In a fearful environment, we retrench, isolate, prejudge, narrow the scope of our understanding, and devote more energy to anxiety than production. These responses are not in our rational self-interest. They are wholly human, however. Recognizing this, we must respond to greater uncertainty not through fear but through genuine understanding and rational thought.