Wanted: An economics of fear

During and after the financial panic of 2008, we were exposed to a host of economists trying to explain the market meltdown, what should be done about it, and how we might avoid repeating it. Some of the leading lights in the discipline weighed in on the market problems. Now we have a reform proposal working through Congress that my fellow Pileus bloggers have written intelligently about (see here, here, and here).

Opinions are wide-ranging. I might share some of my own soon. But what unites all the various economists is a complete and utter cluelessness on the most important variable in the economic meltdown: fear.

Stock markets have been falling and have been highly volatile recently, apparently over the debt crisis in Europe (though I have to say that most media explanations for why markets move the way they do in a given day are complete gibberish). I would not be surprised to see the market slide even further, erasing most or all of the big gains of the past year.

Nothing in traditional finance can say anything useful about fear, nor can the macroeconomists. Perhaps there is something in the “new behavioral finance,” but I’m not aware of anything.  Keynes talked about “animal spirits,” but did not have a systematic theory of fear. To say that people behave irrationally is not a theory. A theory of fear would tell us something about why, when, and how fear develops and how it can be contained or modified. Similarly, we would could use a theory of the exuberance which leads to bubbles in the first place. I don’t think anyone really has a clue.

When the housing bubble burst, a lot of institutions were left holding high number of “toxic assets,” which were mostly mortgage-backed securities. Their price went to essentially zero, even though I cannot conceive of any model that would say a bunch of bad loans should have a zero price (even a really, really bad batch—say one where 50% of the mortgages will default—should still be worth 50 cents on the dollar, shouldn’t it?). Thus, the market went from systematically overvaluing these securities to systematically undervaluing them. What model of investor behavior can explain both phenomena?

Now we have debt problems in a few small European economies. Investors are acting as if the value of that debt is going to zero, though it is hard to imagine a complete collapse of the government that results in any European country simply defaulting on all its debt, though it is possible to think of cases where debt would need to be restructured and bond-holders would lose some value (in fact, the EU should require that to happen, rather than just throwing more money at these irresponsible states). This nervousness, this fear, spills over into other bond markets and into equity markets, which threatens the economic recovery. Systematic fear can be as devastating to an economy as real shocks.

People say that we need to understand the causes of the financial meltdown before proposing solutions. I think there are commonsense reforms that can be made, but these mostly won’t get at the real problem: no one has a clue about how to regulate either exuberance or fear.

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