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The mystery of Wall Street’s stampeding market

Post by Patrick O'Callahan on May 9, 2010 at 6:26 pm |
May 7, 2010 6:29 pm

This editorial will appear in tomorrow’s print edition.

Start with the obvious: Some mysterious gremlin in some murky nook of America’s trading system should not be able to trigger the steepest sell-off in Wall Street history.

For that matter, a small Mediterranean country’s bad debts should not be able to threaten the European economy and spook investors around the world.

And while we’re on the subject, incomprehensible financial products based on fraudulent mortgage schemes should not be able to throw the world into a near-catastrophic credit crisis, as happened in 2008.

Republicans in Congress are attempting a last stand against a Democratic package of sweeping new regulations on financial markets and institutions. The Republicans make the usual points – some of them valid – about the virtues of free markets and the burdens of government restriction. But they’re shouting into a gale.

Americans have seen hundreds of billions of their dollars used to bail out enormous banks, and they aren’t in a mood to let the markets regulate themselves.

The nation overreacts in one direction, then overreacts in the opposite direction. Congress will no doubt loosen some restrictions when it becomes clear which do more harm then good. But right now public sympathy for Wall Street’s wheelers and dealers is running about as low as it was in 1934.

Fortunately, the debacle in Greece has tempered recent enthusiasm for heavy government spending; it’s also quieted the neo-socialists who’d begun sticking their heads up again in hopes that the world had turned their way. The logical alternative to an economy ruled by robber barons is not an economy staggering under ruinous, unsustainable social welfare spending.

Economic theories apparently had nothing to do with Thursday’s brief but terrifying plunge. The likely culprit is some combination of technical flukes, including a possible disconnect between the protocols of different exchanges, or even a typographical mistake. Whatever it was triggered a software-driven frenzy of stock sales.

It’s scary that the geniuses who oversee the trading system couldn’t immediately diagnose the problem, which suggests that we’ve created an electronic monster we do not fully understand or control. The synthetic panic points to an unsuspected vulnerability in America’s financial markets, which amounts to a hole in the nation’s security.

This is the stuff of fantasy thrillers; it shouldn’t happen in real life.

When it comes to markets, Roosevelt was right: The worst nightmare is fear itself. Investors don’t merely react to events; they react to how they think others will react. The psychology of collective panic can magnify bad news a thousand-fold.

On Friday, the gremlin in the system had vanished, European leaders were moving decisively to contain the damage from Greece, and the U.S. government announced surprisingly strong job growth. The markets still fell. We hope this week will be a different story.

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