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Fear FactorHow anxiety and terror are making the financial catastrophe worse than it needs to be.

By Daniel GrossPosted Monday, Oct. 13, 2008, at 10:25 AM ET

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Several psychological factors are at work. The failure of household names such as Fannie Mae, Freddie Mac, Lehman Bros., and AIG saps confidence. "If you feel you can't trust the institutions, it's a trigger for anxiety," says psychologist Paul Slovic, co-founder of Decision Research. After the dot-com bubble burst, he found investors were still optimistic that investing in the stock market would enable them to meet their long-term goals. But in a survey that asked the same question on Sept. 29, the day the House of Representatives voted down the bailout package, respondents were deeply pessimistic about the short term.

Panic in a downturn, much like overconfidence during good times, is a form of social contagion, says Dr. Robert Leahy, professor of psychology at Weill Cornell Medical College. "People just begin listening to each other, and they feed off the bad news, just as they fed off the overly positive good news about housing prices going up four years ago," Leahy says. Next, confirmation bias, the process through which people blow fresh negative developments out of proportion, sets in.

When things start to head south, investors turn to the asset classes or sectors that have been doing well recently, or that tend to do well in bear markets. But this time, the shelters have been blown over by the storm—energy stocks, commodities, emerging market stocks, gold. For decades, money-market funds, which invest in high-quality short-term debt, have been the safest place to stow cash this side of the mattress. But the $3.6 trillion industry was rocked in September when a fund run by industry pioneer Reserve Management "broke the buck"—i.e., the value of its holdings fell below a dollar a share. The news started a run on money-market funds that required federal intervention. Fear then began hitting the market for highly rated municipal bonds, traditionally the safest, most boring place to stow money.

It's not all in our heads, though. For in the last few months, there have been plenty of good reasons to worry about the health of Main Street and Wall Street. Jobs fell by 159,000 in September, the ninth straight month of losses. Auto sales fell by 26 percent. Retailers from J.C. Penney to Nordstrom reported disappointing September sales and began dialing back expectations for the vital Christmas season. The sudden freezing of credit, on top of the poor fundamentals, has killed confidence. In the week from Sept. 18-25, 79 percent of consumers interviewed for the University of Michigan consumer-confidence survey expected a bad economic year, up from 57 percent earlier in the month.

During good times, economists note the presence of a "wealth effect." Higher home or stock values make people feel more financially secure. Now, as home prices continue to fall—down 9.5 percent in September 2008 from the year before—and 401(k)s wither, we're seeing what might be dubbed a "poverty effect." "The heightened financial turmoil that we have experienced of late may well lengthen the period of weak economic performance and further increase the risks to growth," Federal Reserve Chairman Benjamin Bernanke somberly told the National Association for Business Economics in Washington on Oct. 7, a day when the Dow fell 508 points.

Time was, a few well-placed words from the Federal Reserve chairman could bring a market panic to a halt. In the 1990s, global markets had an ironclad faith in the ability of Fed chief Alan Greenspan and his cohorts in the Clinton administration to work their way through economic crises. Bernanke gets no such benefit of the doubt. He and his fellow economic firemen—Treasury Secretary Henry Paulson, Bush, and congressional leaders—have taken bold, decisive action, as they continually remind us. It just hasn't been working for the past year. The bailouts, starting with Bear Stearns in March, and growing in size and frequency (nationalizing Fannie Mae and Freddie Mac, throwing a lifeline to AIG, guaranteeing money-market funds, the $700 billion bailout), seem to only have begat more panic. Why? Since the first measures didn't work, investors fear that the most recent one won't, either. We keep taking injections to fend off the fever. But each time, a larger dosage lasts for a shorter time. Will the latest booster shot—the plan announced Friday, Oct. 10, for the government to take direct stakes in banks—prove to be an effective inoculation?

The protestations from on high are that, underneath the disaster, the fundamentals are still strong, that we'll work through this because we're Americans. "Fellow citizens," Bush fumfered Friday, "we can solve this crisis—and we will." Unfortunately, his reassurances seem about as calming as the scene from Airplane in which the flight attendant urges everyone to remain calm while all hell breaks loose. We have no Churchills today, and our financial leaders all seem to have fled to a bunker. On CNBC, Tyler Mathisen practically begged a name-brand CEO—anyone—to come on the air and speak to the American people.

For now, we have to seek solace in small positive signs: decent earnings from IBM, a week going by without a major financial institution failing. The most crucial indicator of an end to the rising fear may be, counterintuitively, more of it. Students of bubbles note that investor sentiment is always most bullish when a market is about to hit a top and most bearish just when it's about to bottom. (Business Week's 1979 cover story on the "Death of Equities" signaled the start of a long-running stock-market boom.) But when there's nobody left to lose confidence, when Jim Cramer, the ultimate stock guy, throws in the towel and urges people not to buy stocks again until 2013, that sure smells like capitulation.

A version of this article appears in this week's Newsweek.

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Daniel Gross is the Moneybox columnist for Slate and the business columnist for Newsweek. You can e-mail him at and follow him on Twitter. His latest book, Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation, has just been published in paperback.

Illustration by Mark Alan Stamaty.

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