Government Must End Cycles of `Panic' in Stocks, Schelling Says

By Lynn Thomasson and Thomas R. Keene

Oct. 10 (Bloomberg) -- Governments must stop investors from ``anticipating panic'' to end sell-offs that erased more than $25 trillion from global stock markets in the past year, said Thomas Schelling, winner of the 2005 Nobel Prize in economics.

``It's crucial that people believe that help is on the way and solutions are possible,'' Schelling, 87, told Bloomberg Radio. ``If everybody thinks the stock market is going to crash, they behave in a way that makes it crash.''

The Standard & Poor's 500 Index tumbled seven straight days, the longest streak since 1996, after credit markets froze following almost $600 billion in subprime-related losses at banks. The benchmark index for U.S. stocks dropped 42 percent since its October 2007 record. Asian shares slumped today, with Japan's Nikkei 225 losing 11 percent at 1:08 p.m. in Tokyo.

Schelling's specialty is game theory, the study of strategic decision-making. He was a foreign policy adviser to President Harry S. Truman, taught at Yale University and Harvard University and wrote books including ``The Strategy of Conflict.'' Schelling studied nuclear war, addiction and racial segregation.

The stock market is a ``billion-person game in which people are trying to figure out what everybody else is expecting and therefore how everybody else will behave,'' he said.

The third-worst bear market for the S&P 500 is a ``psychological rather than an economic phenomenon,'' Schelling said. Pessimism on U.S. stocks is the highest in almost 14 years, according to an Investors Intelligence poll of newsletter writers in the week ended Oct. 7.

`Fear Gauge'

The market's ``fear gauge,'' as the Chicago Board Options Exchange Volatility Index is known, has tripled since the beginning of September and reached 63.92 yesterday, the highest in its 18-year history. The VIX measures the cost of using options as insurance against declines in the S&P 500.

President George W. Bush signed a $700 billion bank rescue plan last week, an important step toward shifting investor sentiment, Schelling said.

The government may buy stakes in banks, two officials informed of the matter said yesterday. The Federal Reserve, European Central Bank and four other central banks lowered interest rates on Oct. 8 in an unprecedented coordinated effort to ease the economic effects of the worst financial crisis in 75 years. The S&P 500 lost 8.7 percent since.

``I'm not altogether confident that the people in charge know what they're doing,'' Schelling said. ``But they're sure trying hard.''

To contact the reporters for this story: Lynn Thomasson in New York at lthomasson@bloomberg.net; Thomas R. Keene in New York at tkeene@bloomberg.net.