The Nature of Panic

Once again today, the world stock markets are in free-fall as the worldwide herd of investors stampede to the exits. Politicians have that “deer in the headlights” look, and central bankers keep pulling one lever after another hoping that something will work.

The problem, as I see it, is that those in charge may understand economics but they don’t understand human psychology. They are trying careful, rational actions in the hopes of controlling irrational behavior – but it doesn’t work that way.

Human groups en masse behave much like schools of small fish or large flocks of birds, moving as a unit. An economist named Lake LaBaron at Brandeis University has built a simulation of the stock market that can reproduce fairly accurately the sort of irrational herd behavior that often grips the markets, just as it is doing in the real markets today.

American hunters knew that to control a stampeding herd of buffalo it took dramatic actions – gunshots in the air, strategically-placed grass fires, or lines of hunters waving big buffalo skins – to get them to change course.

What governments and central bankers have to understand is that the small, conservative stepwise changes they have been trying day by day can’t control an irrational stampede. It takes big, impressive, dramatic steps to divert a stampede – a “slap in the face” of some sort. In 1933 Franklin Roosevelt declared a bank holiday to stop the run on the banks that he faced, and it worked. Today’s leaders need to try something similarly dramatic to halt the stampede and give spooked investors time to regain their composure and come to their senses.

Recommended: How Did It Happen

Another recommendation is yesterday's article How Did It Happen, by Megan McArdle from the Atlantic Monthly website. And unlike most such posts, many of the reader comments that follow it are not knee-jerk ideological rants but thoughtful and worth reading.

Recommended: The Age of Bloomberg

Fareed Zakaria always seems to cut to the core of a problem. I recommend his recent post The Age of Bloomberg. He argues that this crisis doesn't mean the end of capitalism in the world, but it may well mark the end of America's dominance of the capitalist world.

Recommended: America's Nervous Breakdown

I recommend Victor Davis Hanson's new commentary, America's Nervous Breakdown. As he points out, in the past our enemies have tended to take advantage of our preoccupation with other crises -- will it be any different this time?

Why Washington Can’t Think

Ralph Peters, himself a retired military man, is one of America’s brightest and most unorthodox military observers (see comments on two of his previous books, Beyond Terror and Fighting For The Future in my booklist). I just got from my local library his newest book, Wars of Blood and Faith: The Conflicts That Will Shape the Twenty-First Century. The foreword alone is as full of profound insights as many full-length academic tomes.

But in the present circumstances, with Congress grappling with a series of massive taxpayer bailouts of Wall Street to correct problems that were largely created by Congress itself, I was drawn to the following paragraph in the forward:

“We are led by vultures, not eagles”

“In the middle of the last century, a grand hullabaloo followed the publication of a critique of our educational system, Why Johnny Can’t Read. We are due for a companion volume, Why Washington Can’t Think. The advertising copy for such a book might note that, despite Washington’s status as the richest, most powerful capital city in history, where advanced degrees are ubiquitous, innovative thought not only doesn’t exist, but has become distinctly unwelcome. Washington is incestuous and elitist, as closed to outside ideas as a paranoid religious cult. No matter their party affiliation, insiders at work in government or the media arise from mini-dynasties, attend the same schools and universities, share a disdain for military service, play musical chairs with the same government positions, rotate through the same cluster of (wildly misnamed) think tanks, attend the same usual-suspects policy briefings, read the same books and newspapers, live in the same neighborhoods – and dread the embarrassment threatening anyone who challenges Washington’s dysfunctional, but comfortable, way of interpreting the world.”

I am reminded of the astonishment among members of Congress that there would be such an unexpected backlash against their bailing out Wall Street. Emails to members of Congress were reported to be running about 100-1 against the initial bailout plan. They could only have been astonished at this reaction if they were completely out of touch with the mood of the country.

I am reminded of the astonishment in Washington that we were not greeted in the streets as liberators in Iraq when we overthrew their government. Washington insiders could only have been astonished at this if they were completely ignorant of the long history of the Middle East.

I am reminded of the astonishment of Washington that Russia has reverted to a bellicose, expansionist, authoritarian form of government under Putin. They could only have been astonished at this evolution if they were completely ignorant of the Russian national psyche, humiliated at being demoted from a world power and with memories of German World War II aggression still fresh in their minds.

It seems to me that events in recent years support Peter’s assessment of our governing establishment as hopelessly out of touch with the real world, deluded by their comfortable ideologies (both liberal and conservative), and largely ignorant of history or the lessons history can teach.

Obama, Foreign Policy Realist

I have enormous respect for Fareed Zakaria, and have several of his excellent books listed in my booklist (see sidebar). I strongly recommend his recent article Obama, Foreign Policy Realist. There have been many claims that Senator Obama is a far-left, dewy-eyed idealist. Fareed disagrees, and makes the case that in fact he is a foreign policy realist in the mold of Henry Kissinger, Zbigniew Brzezinski and Brent Scowcroft.

The root of the problem

In all this panic about the markets and Wall Street there has been a lot of glib and partisan finger-pointing about whose’ fault it was that we got into this situation. A little quiet reflection, and some research, leads me to conclude that at root, the fundamental errors that probably got us into this situation include (not necessarily in priority order):

1. Failure by the SEC to enforce existing regulations. No doubt some will argue for a slew of new and more restrictive market regulations in the wake of this debacle, but it’s not clear to me that we need more regulations – just effective enforcement of the existing regulations. A reasonable summary of the SEC’s regulatory failures can be found at http://seekingalpha.com/article/96487-5-failures-of-sec-chairman-cox. To be fair to SEC Chairman Cox, Congress has kept the SEC’s funding almost flat throughout the recent years of Wall Street growth, and they are badly understaffed. And administrations from President Reagan through to the current administration, including President Clinton’s administration, have given clear instruction to regulatory agencies throughout the government (including the SEC) to interfere less, not more, with private markets.

2. Failure of the bond rating agencies such as Standard & Poors and Moody’s to do their jobs. Many of the debt instruments which are now almost worthless were rated AA or even AAA by these agencies. Some previous employees of these agencies are now admitting that in recent years they were ordered to simply accept the rating suggested by the investment banks that issued the bonds, rather than independently verifying the creditworthiness. No doubt the fact that the rating agencies depend on fees from the very investment banks they are assessing influences this behavior.

3. Failure of shareholders to demand better information and more accountability from the management of firms they invest in. Obscene executive pay is probably not a root cause of this mess, even though it has powerful political implications. But it probably is a symptom of the failure of shareholders to demand more of management. Some will argue that shareholders have little power to make such demands, but that is false. Investors have all the power – they can simply refuse to buy shares in a company whose management doesn’t act responsibly. Shareholders who don’t perform “due diligence” before buying shares in a company deserve whatever befalls them. I would bet that few individual investors even bother to read the prospectus of a company before buying shares, let alone demand management accountability.

4. Congressional pressure on Fanny Mae and Freddie Mac to increase financing of “affordable housing”. Part of the recent history of that effort is documented at http://online.wsj.com/article/SB122212948811465427.html. Briefly, Congress pressured these agencies to accept more sub-prime loans, and since Freddie Mac and Fannie May would buy them (as Congress ordered), that created a good market for them and encouraged banks to make more of them. Actually, subprime mortgages originated back in 1977 in the Carter Administration with the Community Reinvestment Act (CRA), an effort to help more people own their own homes. Yet another example of “good intentions” leading to bad policy.

Those partisans who are hell-bent on blaming the whole mess on the current administration ought to know that Republicans tried to get legislation enacted in 2003 to regulate Fannie Mae and Freddie Mac, but were fiercely opposed by Democrats who claimed we were “not facing any kind of financial crisis” (Rep. Barney Frank, D-MA, current Chairman of the House Financial Services Committee.).

5. The abysmal level of American public education. Behind the bad mortgages now choking the system are a slew of gullible American home buyers who, for one reason or another, took out a loan they were not in a position to pay back. Some fell for balloon mortgages or adjustable-rate mortgages without understanding the (rather simple) math behind them, or the (rather obvious) risks they entailed. Some “flipped” houses, trying to make a profit on a housing market they thought could never go down. Some were simply conned by their real estate agents and banks into buying a bigger house than they could afford. One wonders if this could have happened if American schools taught children even the most basic facts about real life or how to handle money.

6. The short-term focus of American society. Asian societies think in terms of decades, generations, even centuries. America thinks in terms of months, quarters, and occasionally a year or two. We suffer from national ADD (Attention Deficit Disorder). Far too often management, shareholders, and government leaders alike think short-term, with little or no attention to possible long-term consequences.

These are all fundamental structural problems with our government, our financial system and our society, and they are not going to be solved quickly or easily. Indeed, with our present government system, it’s hard to see how they will even be addressed, but address them we must if we are not to have a repeat of this sort of crisis, or indeed a total economic disaster.