Dry up the market's fears
Greenspan's admission of a mistake points to a need to rebuild trust.
Looking back on how the Panic of 2008 ended, historians might some day see a turning point in last week's testimony by Alan Greenspan. The former Federal Reserve chief admitted to Congress that he made a mistake. It matters less what the mistake was that he fessed up at all.
His apology helped expose the limits of financial expertise, especially the kind that relies on numbers and computer models, and the need for deeper thinking about how people's core values drive markets.
Mr. Greenspan said he erred "in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms."
In other words, financiers forgot whom they worked for and threw caution to the wind in borrowing and lending. Their false pretense of endless riches and well-calculated risks has now led to market panic.
If Greenspan "the maestro" failed in understanding basic human behavior, then the public needs to fall back on something other than financial experts to help keep the economy going. The questions at stake amount to more than ideological arguments over more or less financial regulation, for instance.
The "fundamental" of any economy is trust among participants that they will make good on their promises. The opposite of that trust is fear, which now pervades global finance. Far too many institutions went out on a limb in lending and are being forced to pull back. But as they clean up their mess, the world must also deal with that less tangible aspect, a contagion of fear.
The markets, true to form, even have a "fear gauge." The Chicago Board Options Exchange has a Volatility Index, which is described as a "key measure of market expectations of near-term volatility."
One economist, Milton Ezrati of Lord Abbett mutual funds, says fear will dominate more than any fundamental if markets don't pick up soon: "Investors will have created their worst fears – a self-fulfilling prophecy if ever there was one."
The mostrecent poll by the American Association of Individual Investors shows that investors of this type are evenly split on being either bullish or bearish. In September, they were far more bearish. Global stocks, too, are up and down, suggesting a mentality of uncertainty based on ignorance of financial reality.
Ignorance, of course, is at the root of most fears, and markets are trying to shed it as fast they can by reassessing the value of loans.
But to help calm fears, people expect action by government. Reassuring words go only so far. John McCain reminded voters that America's economic fundamentals are still sound, while Barack Obama said, "This isn't a time for fear or panic."
The $700 billion rescue plan has only begun, and it remains to be seen if buying up bad assets will work or if the amount is too little. The plan, like many New Deal programs, may help prevent a further spiral downward.
Restoring markets to health requires lessening fear and building up trust. Greenspan's admission is a necessary first step to find that trust again. If more financial leaders from Wall Street to Washington to Main Street can admit their mistakes, markets can gain a more solid footing and a renewed confidence. Perhaps then even the fear of fear itself might evaporate.