his 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 U.S. financial institutions are currently pricing in almost a 70 percent 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.
There is little in recorded history about panics of this magnitude. Perhaps the closest analogue is the Panic of 1907, which economic historians believe was set off by massive losses associated with the San Francisco earthquake a year earlier.
Because this is a once-in-a-century event, policy makers have proceeded in an ad hoc and often confusing manner. Investors and traders haven't been able to guess the U.S. government's next move, and that has exacerbated the stampede.
The rush to search for historical comparisons has inevitably pushed analysts to the Great Depression, which Federal Reserve Chairman Ben S. Bernanke has studied extensively. Others see parallels with the Panic of 1907 or even the Panic of 1837, in which almost a quarter of chartered U.S. banks disappeared.
Searching for lessons from those lost passages of history is a painful stretch. So much has changed.
Moreover, the reliance solely on past financial panics as a guide for optimal policy is myopic. While we have very little experience with such events, we have all too much experience with panics in general. The fact is, we already know how to stop them.
We know the playbook, but we are not following it.
SARS Epidemic
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 percent. Absenteeism skyrocketed, and China's gross domestic product dropped 5 percentage points in one quarter. Similar losses spread to Hong Kong, Taiwan and Singapore.
A fascinating review of the episode by World Bank economists Milan Brahmbhatt and Arindam Dutta reports that almost 25 percent of survey respondents in Hong Kong thought they were very likely to get the disease. In another survey, most respondents said if they contracted the disease, they were highly likely to die. The actual fatality rate: 11 percent.
Herd Behavior
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 recognized that herd behavior was inducing rational individuals to form subjective beliefs that the plague would be catastrophic.
If your neighbors decide not to go to work, then that indicates they believe something terrible is afoot. That observation influences your belief, and then your decision to stay home affects the beliefs of others.
Brahmbhatt and Dutta use the Singapore government's response as a model for effective behavior. 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.
Stopping the Panic
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 behavior can drive beliefs to crazy places, as appears to be happening in financial markets.
The Singapore response sets a goal for policy makers. They need to tell us who has the disease, how they will quarantine those who have it, what the treatment will be if it's discovered, why that treatment will work, and the steps we can all take to avoid infection. They need to do this with facts and transparency, not with spin and assertion.
That sounds like a tall order, but there are a number of simple steps that could have a calming effect on markets.
Good Start
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?
As of yet, 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.
(Kevin Hassett, director of economic-policy studies at the American Enterprise Institute, is a Bloomberg News columnist. He is an adviser to Republican Senator John McCain of Arizona in the 2008 presidential election. The opinions expressed are his own.)
