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The psychology behind market panics

A stock specialist watches prices on the floor of the New York Stock Exchange.

Jeremy Hobson: Now a 2.5 percent drop would probably not be considered a market panic. But consider that just in the month of September, the Dow has had 10 swings of a hundred points or more.

The markets are on edge -- but are they panicking?

Marketplace economics correspondent Chris Farrell joins us now to discuss. Good morning, Chris.

Chris Farrell: Good morning, Jeremy.

Hobson: Well what is considered a market panic?

Farrell: Market panic, 1987: stock market falls by about 25 percent -- that is a market panic. Essentially what happens -- and it's happened throughout our history, the first one was in 1792 or that's the one that we talk about with William Dewar, who was a friend of Alexander Hamilton, the first treasury secretary -- what happens in a market panic is that institutions, the big buyers, they realize that there's danger. They realize they're going to lose a lot of money. They withdraw from the market; sellers realize, 'hey, there's no buyers, we've got to lower price.' And then, a market panic sets in, and it feeds on itself in a downward spiral.

Hobson: But doesn't it always turn out afterwards that these investors go, 'That was a real mistake. Why did we panic so much?'

Farrell: Well of course. And you also wonder during the boom times how could so many people be so stupid to borrow so much money to invest? So in a way, though, it's very rational the actions that are happening. That's what's so scary about panics and that's why panics exist, because what happens is that these institutions are protecting themselves. They realize that they could lose a lot of money, they withdraw from the market, but that withdrawal from the market is what feeds the panic itself.

Hobson: Is there economic thought out there about how to stop these panics from happening?

Farrell: There's a very simple way to stop a panic, and the classic example is 1907: stock market panic, JP Morgan -- the legendary investment banker -- he said, 'Stop! We are backing the system.' And it worked. And then we created the Federal Reserve. One of its jobs is during a market panic, for example in 1987 and in 2008, the Federal Reserve says, 'Stop! We will support the financial system -- don't panic. Yes, you can knock down the value of stocks or bonds or whatever, but there's no need to panic.'

Hobson: Do you think we're in a period right now where we're prone to market panics? Do we know if we're prone to market panic?

Farrell: We're absolutely prone to market panics because we've moved toward a world of computers and algorithms and they move so fast. They move faster than human judgement. So we're more prone to it than ever before, and we have a situation where it could happen, it could not happen, because of all the uncertainty that's out there about the economy and Europe.

Hobson: Marketplace economics correspondent Chris Farrell, thanks so much.

Farrell: Thank you.

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Banks have become more risky since the Glass-Steagall repeal in the '90s. Investment banking and commercial banking are combined. Credit default swaps and other speculative devices are going to continue to create fear in our banking system. Bring back the good old days.

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