SARS Response Offers Lessons for Bringing Calm to Panicky Markets
Bloomberg 7 October 2008
This is what a panic looks like.
Banks have practically stopped lending to one another. Risky assets are so toxic that the 10-year bonds of US financial institutions are currently pricing in an almost 70 per cent chance of default, a rate that is an order of magnitude higher than anything that has happened in the past 40 years. Investors are flooding to the exits, and taking whatever prices they can get if the reward is liquid cash.
Investors and traders haven’t been able to guess the US government’s next move, and that has exacerbated the stampede.
Panics are, after all, far too common. Perhaps the most recent was the 2003 Sars epidemic in Asia.
Back then, a relatively small number of cases of severe acute respiratory syndrome (fewer than 26 per 100,000 in Hong Kong, for example) led to a massive panic. Beijing tourist attractions reported revenue losses of 80 per cent. Absenteeism skyrocketed, and the mainland’s gross domestic product dropped 5 percentage points in one quarter. Similar losses spread to Hong Kong, Taiwan and Singapore.
Sars caused a panic because people didn’t know much about the disease and couldn’t tell if the person next to them with the sniffles was a disease-bomb set to kill.
The panic ended long before the threat from Sars was over. The reason: Governments recognised that herd behaviour was inducing rational individuals to form subjective beliefs that the plague would be catastrophic.
In a review of the episode, World Bank economists Milan Brahmbhatt and Arindam Dutta used the Singapore government’s response as a model for effective behaviour. The authorities provided daily updates of the situation, detailing “the nature of the disease, symptoms, transmission mechanism, numbers of infections, fatalities, chances of recovery and preventive health-care information”, they wrote.
Perhaps as a result, subjective probabilities of infection in Singapore, as revealed in public surveys, were half what they were in Hong Kong.
Panics stop when citizens understand that those with the disease have been identified and quarantined, know what the treatment options are and can take sensible precautions to avoid infection. If we never developed a test for Sars, we would probably still be panicked. Without such information, herd behaviour can drive beliefs to crazy places, as appears to be happening in financial markets.
Buying troubled assets may be a good start, as cash is intrinsically easier to value than illiquid mortgages, but that cannot be the end. Regulators need to assure markets that they have pored over the books of financial institutions and identified those that are sick and those that aren’t.
If bonds seem to be factoring in ridiculously high corporate default rates, the Treasury secretary could say so, and back it up with balance-sheet analysis and historical precedents. Government leaders also should explain why the treatments they choose will be successful. Finally, citizens should be advised and reassured: Is their money safe? Should they also liquidate troubled assets, or hold on?
So far, Federal Reserve chairman Ben Bernanke and Treasury Secretary Henry Paulson have responded aggressively, but not in a transparent and reassuring fashion.
They don’t seem to understand that their silence in these key issues, like that of the Chinese government in 2003, is scary.
SARS Response Offers Lessons for Bringing Calm to Panicky Markets
ReplyDeleteBloomberg
7 October 2008
This is what a panic looks like.
Banks have practically stopped lending to one another. Risky assets are so toxic that the 10-year bonds of US financial institutions are currently pricing in an almost 70 per cent chance of default, a rate that is an order of magnitude higher than anything that has happened in the past 40 years. Investors are flooding to the exits, and taking whatever prices they can get if the reward is liquid cash.
Investors and traders haven’t been able to guess the US government’s next move, and that has exacerbated the stampede.
Panics are, after all, far too common. Perhaps the most recent was the 2003 Sars epidemic in Asia.
Back then, a relatively small number of cases of severe acute respiratory syndrome (fewer than 26 per 100,000 in Hong Kong, for example) led to a massive panic. Beijing tourist attractions reported revenue losses of 80 per cent. Absenteeism skyrocketed, and the mainland’s gross domestic product dropped 5 percentage points in one quarter. Similar losses spread to Hong Kong, Taiwan and Singapore.
Sars caused a panic because people didn’t know much about the disease and couldn’t tell if the person next to them with the sniffles was a disease-bomb set to kill.
The panic ended long before the threat from Sars was over. The reason: Governments recognised that herd behaviour was inducing rational individuals to form subjective beliefs that the plague would be catastrophic.
In a review of the episode, World Bank economists Milan Brahmbhatt and Arindam Dutta used the Singapore government’s response as a model for effective behaviour. The authorities provided daily updates of the situation, detailing “the nature of the disease, symptoms, transmission mechanism, numbers of infections, fatalities, chances of recovery and preventive health-care information”, they wrote.
Perhaps as a result, subjective probabilities of infection in Singapore, as revealed in public surveys, were half what they were in Hong Kong.
Panics stop when citizens understand that those with the disease have been identified and quarantined, know what the treatment options are and can take sensible precautions to avoid infection. If we never developed a test for Sars, we would probably still be panicked. Without such information, herd behaviour can drive beliefs to crazy places, as appears to be happening in financial markets.
Buying troubled assets may be a good start, as cash is intrinsically easier to value than illiquid mortgages, but that cannot be the end. Regulators need to assure markets that they have pored over the books of financial institutions and identified those that are sick and those that aren’t.
If bonds seem to be factoring in ridiculously high corporate default rates, the Treasury secretary could say so, and back it up with balance-sheet analysis and historical precedents. Government leaders also should explain why the treatments they choose will be successful. Finally, citizens should be advised and reassured: Is their money safe? Should they also liquidate troubled assets, or hold on?
So far, Federal Reserve chairman Ben Bernanke and Treasury Secretary Henry Paulson have responded aggressively, but not in a transparent and reassuring fashion.
They don’t seem to understand that their silence in these key issues, like that of the Chinese government in 2003, is scary.