The Fear Factor Also by Colin Read GLOBAL FINANCIAL MELTDOWN: HOW WE CAN AVOID THE NEXT ECONOMIC CRISIS INTERNATIONAL TAXATION HANDBOOK: POLICY, PRACTICE, STANDARDS AND REGULATION (edited with G. Gregoriou) The Fear Factor What Happens When Fear Grips Wall Street Colin Read © Colin Read 2009 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6-10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2009 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN-13: 978–0–230–22846–7 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. 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A catalog record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 18 17 16 15 14 13 12 11 10 09 Printed and bound in Great Britain by CPI Antony Rowe, Chippenham and Eastbourne I dedicate this book to my fiancé and wonderful partner, Natalie, and my mother, Gail This page intentionally left blank vii Contents List of Figures ix Preface x About the Author xi Introduction 1 Part I The Nature of Risk 5 1 The Biology and Psychology of Fear 7 2 An Economic Definition of Fear and Risk 16 Part II The Supply and Demand of Loanable Funds 19 3 The Demand Side 21 4 The Supply Side 32 5 Balance of Capital 44 Part III Measurement of Risk 51 6 The Risk Premium – How Risk Affects Expected Returns 53 7 The Fear Premium 59 8 The Demographics of Risk and Fear 67 9 The Microeconomics of Risk Aversion 76 Part IV The Problems with Risk 83 10 Moral Hazard 85 11 Privatized Gains and Socialized Losses 93 12 Adverse Selection and Imperfect Information 105 13 Risk, Uncertainty, Fear, and Gambling 112 Part V Risk and the Market 119 14 Market Volatility and Returns 121 viii Contents 15 Fear, Panic, and Market Returns 126 16 The Fear Factor 132 Part VI A History of Panics 137 17 A Brief History of the Fear-Gripped Market 139 18 The Roaring Twenties and the Great Crash 151 19 The Depression-Gripped Economy 156 20 Along Comes Keynes 162 Part VII Coordination Failures 171 21 The Market for Lemmings, or A Tale of Two Cultures 173 22 The Role of Machines and Programmed Trading 179 23 The Ratings Agencies – More Perfect Information? 184 Part VIII Social Responsibility as an Antidote to Fear 189 24 Where Were the Regulators 191 25 Ethics and Social Responsibility 202 26 Wall Street, Main Street, and the Social Contract 207 Part IX Institutions That Ameliorate or Amplify Fear 213 27 The Media as an Antidote to Fear 215 28 Politics That Fan the Flames of Fear 221 29 Is There More to Fear than Fear Itself? 223 Part X Solutions to an Economic Quagmire 227 30 Economic Leadership as an Antidote to Fear 229 31 A Dozen Prescriptions to Take Back the Markets 232 Conclusions 239 Notes 241 Glossary 244 Index 247 ix Figures 3.1 An Upward Sloping Utility Curve 22 3.2 Demand Curve 24 3.3 Aggregate Demand 25 3.4 Demand for Loanable Funds 26 5.1 U.S. Imports, Exports, and the Trade Deficit 1960–2007 46 6.1 Average Utility 54 6.2 Decreasing Risk Aversion with Higher Consumption and Income 56 6.3 Much Smaller Risk Premium if Risk Is Spread over Two Periods 57 7.1 Utility Curve with Decreasing Marginal Utility 60 7.2 Fair Gambles of $5,000 on a $10,000 Income 60 7.3 Comparison of Gambles with a Certainty Equivalent 60 7.4 Gambles and the Cost of Risk 61 7.5 Increasing Levels of a Fair Gamble 61 7.6 Increasing Fear and Risk Premium with Larger Fair Gambles 62 8.1 The Pattern of Savings over a Life Cycle 73 9.1 The Portfolio of Possible Returns and Risk 79 9.2 The Efficient Portfolio Frontier and the Risk-Free Return 80 9.3 The Capital Allocation Line 80 9.4 Varying Return/Risk Trade-offs for Different Individuals 81 9.5 Different Return/Risk Trade-off Points for the Same Individual Facing Different Investment Opportunities 82 9.6 Different Portfolio Choices for Low and High Risk Tolerance Investors 82 14.1 Different Portfolio Choices for Low and High Risk Tolerance Investors 122 14.2 The Effects of an Increasingly Risky Market 122 15.1 The New York Times Panic Index 1928–2008 127 15.2 NY Times Panic Index and DJIA Returns 1929–2008 128 15.3 NY Times Panic Index and DJIA Returns 1991–2008 128 15.4 NY Times Panic Index and the VIX Fear Index 1990–2008 129 15.5 NY Times Panic Index and Changes in the VIX Fear Index 1991–2008 130 15.6 Changes in the NY Times Panic Index and the VIX Fear Index 1991–2008 130 16.1 The Fear Index and DJIA Returns 1997–2008 133 16.2 Changes in Volatility (VIX) and Financial Profits 1991–2008 134 x Preface Over the months between writing Global Financial Meltdown and completing this book, the economies of the world have been shocked in a manner with- out parallel. Families around the world have become fearful for their financial future. As of today, these fears remain unabated. Just two years ago, if one were to spoil the economic party by pointing out the fragilities of our global economy, there would be no warm reception. Now, one cannot watch a newscast or open a newspaper without seeing numerous stories of fear and misery. Unlike two years ago, almost all are calling for very significant reform to prevent this misery from ever occurring again. We have seen our worst economic fears. And we now understand that these fears translate into action designed to protect our collective economic future. Time is ripe to better understand the nature of our economic fears. In doing so, we can also understand how our fears are manipulated by others in their pursuit of profits. By understanding how some can capitalize on our fears, we will be better able to create the reforms and institutions that can rebuild our confidence in markets and investments. In the process of writing this book, I also conclude that there is a need to reemphasize the pursuit of true production rather than the mere production of paper profits. Greed and excess has replaced toil and sweat, and has our brightest young minds aspiring to Wall Street rather than Main Street. A con- sequence of fear-driven markets is a renewed recognition of the value of true production. Just as we recall those circumstances that have placed us in peril before, our memories of these economic perils will hopefully motivate us to demand reform and not repeat excesses. I view the messages and the focus on market fear as productive. Information is power, and an understanding of markets and of our human response to threats will allow us to better cope with the gyrations of markets and the uncertainties of economic life. An embracement of economic fear, through understanding, can be empowering rather than debilitating. I hope as you read this book you will try to integrate the lessons on these pages into your own economic life. Our economic challenges will abate, and our fears will pass. We will be left with an emotional memory of circumstances that have placed us all in great discomfort. And our fears will allow us to recog- nize, right in the solar plexus, those economic circumstances that can threaten our economic security. Colin Read Plattsburgh, New York April 21, 2009 [...]... convinced this once-in-a-lifetime event when fear grips the market necessitates a less doctrinal discussion of the free market So I devoted my research to the explanation of market failures to the public I stepped down from my job as the dean of a school of business and economics at the State University of New York to write a regular business column and a book that documents the unraveling of the current... do not experience the fear directly can now vicariously feel the anxiety by watching the evening news The common media expression “if it bleeds, it leads” reinforces our fascination with fear inflicting others, viewed from the comfort and safety of our own environment The Biology and Psychology of Fear 9 These traumas of the most basic type inflicted on others may even have a somewhat cathartic effect... 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,... together in groups with shared values, religion, culture, language, tradition, heritage, or location in hope of survival and prosperity Whenever the core characteristic that bonds a group together comes under threat, the group will inevitably fear for its very survival They’ll attempt to change the situation that poses the threat, or, failing that, they will attempt to repel the threat and strengthen their... complex and uncertain in others.2 These new reasons to fear are the subject of this book Though gone are the fears of predatory animals, falling from trees, or unannounced disasters, we are still left with a multitude of fears of the unknown As our sphere of the known has dramatically expanded, so too has the range of possible unknowns Fear of animals has been replaced by fear for our economic and... recognize the incredible advantages of free markets and capitalism, when they work well I am also quick to judge these same markets harshly when they fail to perform as promised Unfortunately, market failures are now colossal, and the pain inflicted when markets fail so dramatically and quickly outstrips the goodwill generated when the markets work well My previous book reinforced in me the importance... to soothe our fear of economic entrapment We then become fearful of any loss in our wealth, and we become less free to explore new opportunities Even the fear of loss of health care makes some fearful of changing jobs The trapping of our fear of loss of economic security is our loss of economic freedom This fear seems to pervade all of society in these perilous times And, for this fear there seems to... our security and well- being, then the world is fast becoming a more fearful place The irony is that technological progress has for hundreds of years advanced the financial security of most of the First Economic World This group, the main recipients of the fruits of technology flowing from the Industrial Revolution, has increased its wealth manyfold At the same time, though, and for the same reasons,... more of the activity should give us a higher level of satisfaction In other words, if we graphed our level of satisfaction against the quantity q of consumption of the good, the graph would be upward sloping Economists traditionally label the horizontal axis the quantity axis that denotes the number of units of the good we enjoy The vertical axis is labeled the utility scale, derived from the admittedly... consider themselves thrill seekers, enjoying their ability to control what would otherwise be fearful environments This points to an associated characteristic that differentiates uncertainty and fear We are fearful when we are exposed to risk, defined as an uncertain outcome that deprives us of our economic security, combined with a lack of control of the outcome Fear implores us to assess the uncertainty, . PRACTICE, STANDARDS AND REGULATION (edited with G. Gregoriou) The Fear Factor What Happens When Fear Grips Wall Street Colin Read © Colin Read 2009 All rights reserved. No reproduction, copy or transmission. 202 26 Wall Street, Main Street, and the Social Contract 207 Part IX Institutions That Ameliorate or Amplify Fear 213 27 The Media as an Antidote to Fear 215 28 Politics That Fan the Flames of Fear. frustration with the recent Global Financial Meltdown that I became convinced this once-in-a-lifetime event when fear grips the market necessitates a less doctrinal discussion of the free market. So