Wall Street Fear

The following essay was initially published in the Fall 2010 issue of Phi Kappa Phi Forum, the member magazine of the National Honor Society of Phi Kappa Phi.

By John T. Harding

   The only thing we have to fear is fear itself.
 — Franklin D. Roosevelt, from his 1933 presidential inaugural address

   Fear is a major factor that drives Wall Street. Financial history is full of examples of investors succumbing to it and causing widespread economic damage, including fallout from the Great Crash of 1929 and the lesser-known Panic of 1907.

   A cynic might say that while Wall Street is populated by bulls and bears, investors are sheep and cattle, often driven by fear — and its companion, euphoria. Despite many financial history lessons showing that neither is a reliable motivation for fiscal decisions, investors continue to delude themselves into thinking that “this time is different” and that they’ve defeated the inevitable business cycle, thus changing the rules forever.

   “The U.S. subprime crisis of 2008 followed the script of scores of banking crises past,” wrote Paul Krugman and Robin Wells in their review of Carmen Reinhart and Kenneth Rogoff’s This Time is Different: Eight Centuries of Financial Folly (for The New York Review of Books, May 13 edition). The core of that folly, Krugman and Wells noted, is that “too much debt is always dangerous,” whether the borrowing is by governments, financial institutions or individuals. “Yet people — both investors and policymakers — tend to rationalize away these dangers,” the reviewers added; “they either forget history or invent reasons to believe that historical experience is irrelevant,” thus setting themselves up for disaster. 

   Economic historian Charles P. Kindleberger put it this way in his often-reprinted 1978 book, Manias, Panics, and Crashes: A History of Financial Crises: “Asset price bubbles — at least the large ones — are almost always associated with economic euphoria.”

    At some point, however, the delusion fades. And as John Maynard Keynes wrote in his 1936 classic book, The General Theory of Employment, Interest and Money, “It is of the nature of organized investment markets ... (that) when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and catastrophic force.”

   This happened in the Panic of 1907 when rumors — some true, some false — sent frightened herds of depositors stampeding to banks, brokerages, and other financial institutions to rescue their cash before firms went belly up. Such a run, however, only made things worse. For example, the stock of United Copper Co. fell from $62 to $15 in only two days after a failed effort by a speculator to corner the company’s shares. And depositors withdrew $8 million in three hours from the Knickerbocker Trust Co. in New York City before the bank suspended operations, according to an historical pamphlet prepared by the Federal Reserve Bank of Boston.

   There was no deposit insurance or investor protection for customers; there was no government agency or central bank to bail out troubled firms. So as the panic spread, financier J. P. Morgan rounded up colleagues to organize a rescue operation, depositing cash with troubled banks and brokerage firms.

   Some six years later, the Federal Reserve Act was signed by President Woodrow Wilson, establishing an independent central banking system to regulate the nation’s financial institutions, monitor the economy, and control the supply of money.

   Disillusion, Keynes noted, “comes because doubts suddenly arise concerning the reliability of the prospective yield,” among other reasons. And when the investment herd perceives a lack of reliability, fear kicks in, as in, most famously, the stock market crash of 1929.

   The tsunami of stock market speculation that led to the Great Depression began to build early in 1928, according to Harvard economist John Kenneth Galbraith in his 1954 bestseller The Great Crash of 1929. This “mass escape into make-believe, so much a part of the true speculative orgy,” Galbraith wrote, “started in earnest,” and as the words of brokers and investment counselors “became golden,” audiences listened “with the truly rapt attention of those who expect to make money by what they hear.”

   Eventually, however, the foggy air of overconfidence was blown away by the winds of economic reality, and the panicked populace demanded their money back, rushing to retrieve what little may have been left of their invested hopes and dreams. By mid-October 1929, disillusioned investors lost confidence, dumped their stocks, and the market crashed.

   While the 1907 episode is also known as “the Rich Man’s Panic” because it directly affected mostly wealthy people, during the 1920s, millions of average Americans had poured their savings into the stock market. Hundreds of banks failed in the first six months of 1929 and hundreds more during the ensuing Great Depression; stocks lost an estimated $50 billion over the two years following the crash; and the jobless rate during the Great Depression soared to a staggering 25 percent.

   Just as the Panic of 1907 led to the creation of the Federal Reserve, the Great Crash of 1929 led in 1934 to the Federal Deposit Insurance Corporation, also an independent entity, whose mission is to cover the assets of depositors, easing their fears when banks become insolvent.

   And it may be coincidence, but it is curious that the last four major financial crises in America happened in October (1907, 1929, 1987, 2008) — just before Halloween.