Managing "Fear Itself"

There are lessons to all of us in watching how Secretary Paulson and Chairman Bernanke manage the financial crisis. Last night on Larry King Live* Ben Stein, who most folks consider an adorable comedian but who is quite a good economist and of course his dad was Chairman of the Council of Economic Advisors under Nixon and Ford, attributed the immediate liquidity crunch the economy is under to the failure to bail out Lehman Brothers. In essence, that triggered a panic and it's the panic that got the market into a tizzy.

Later that evening, Warren Buffet was on Charlie Rose and Buffet sang the praises of Hank Paulson as the right person for the job, somebody who understood the situation completely and got things done.

Only in retrospect did it occur to me to consider the Lehman situation akin to Rumsfeld's original approach to the Iraq War, where he argued that you go with the army you have and that limited troop deployment was the right strategy for the job. The Military brass wanted overwhelming force. The surge didn't happen till four years later and, of course, the resource commitment to the War is ongoing.

But the difference between financial decision making and military deployments is that the role of expectations in the former is much more clearly understood. And in the case of Lehman there had been these other rescues fairly recently. So it is puzzling that the bankruptcy was allowed to happen - though there is also the logic that if Lehman was going to fail even if the the economy righted itself then it should be allowed then and there rather than be propped up at tax payer expense only to fail later. That is the logic of Ed Leamer's piece at the Economist's voice.

Much of the behavior of markets results from making inferences based on recent news. Panic is rational when others panic. But the early ones to panic may do so because they make the inference incorrectly. Inferences are always subjective and uncertain. It's guesswork. Being smart is in large part making good guesses. But even the smartest folks sometimes make the wrong judgment.

Everyone in the financial community has been reading the moves by the Fed and the Treasury to figure out what they should do. There is a signaling aspect to the behavior of Bernanke and Paulson that is not in Leamer's analysis.

The same type of signaling goes on in Higher Ed. Gossip abounds. Folks make inferences all the time. Everyone I know is always trying to figure out what really is going on. And the lesson is that choices that may seem quite rational to the highly situated decision maker get misinterpreted as a signal and then things go awry. Managing that is extremely difficult. But transparency is probably the best approach long term.

It really would be good to understand the thinking behind why Lehman was allowed to fail. For the Monday morning quarterback, it doesn't appear to make sense.

*It's great to see a commercial media company like CNN make transcripts available of its programming. This makes what the produce have much greater archival value and provides sustenance for the rest of us to discuss the content of their shows after the fact.