By Matthew Benjamin and Michael McKee — October 9, 2008 03:57 EDT

Oct. 9 (Bloomberg) — Greed and fear are the emotions that rule markets. Fear is winning.

U.S. and European stock markets fell yesterday, even after the Federal Reserve lowered its benchmark interest rate in concert with central banks in Europe, Canada and China.

Investors are in the grip of a panic that psychologists and historians say isnt necessarily rational and may intensify. They arent buying stocks. and more importantly, suddenly afraid they wont be repaid, they arent making loans by buying bonds. Banks have also tightened credit.

«People are driven by images of the best and worst that can happen, says George Loewenstein, a professor of psychology and economics at Carnegie Mellon University in Pittsburgh. «The image of the worst is much more vivid in their minds right now.

The fear that has frozen credit markets means Ellen Logan cant sell her Chicago-area condominium. In Los Angeles, Ron Schwartz cant replace his wifes old car. In Seattle, Lisa LeVere is buying only the bare necessities. Consumer spending is two-thirds of gross domestic product. If Americans close their wallets, recession — or worse — is all but certain.

Fear that an economic contraction will mangle corporate earnings has driven the Dow Jones Industrial Average down 30 percent so far this year. The S&P 500 index is off 33 percent.

The widespread fear of losses has taken John Maynard Keynes s so-called animal spirits, «a spontaneous urge to action rather than inaction, out of the markets.

Last in Line

«Everyone is worried about getting paid, says William Silber. a New York University economist and author of «When Washington Shut Down Wall Street: The Great Financial Crisis of 1914. While thats a rational feeling for an individual, panics happen when everyone tries to act on their fears at once. «No one wants to be the last one in line, Silber says.

Normally, a little fear is a good thing, economists say. For decades after the 1930s, memories of the Great Depression tempered optimism and kept asset bubbles from growing too large.

Todays fears, however, have reached an intensity that magnifies every additional piece of information and creates a vicious circle, according to Hersh Shefrin, professor of behavioral finance at Santa Clara University in California.

Wall Streets so-called fear index, the VIX. measures the cost of using options as insurance against stock-market losses. It reached an intraday record of 59.06 today.

Questionable Prospects

The failure of Bear Stearns in March led investors to question the prospects for Lehman Brothers and other investment banks. Concern about the financial holdings of Fannie Mae and Freddie Mac led to a government takeover of the mortgage lenders in September.

That led to fear about the viability of insurance giant American International Group. which in essence had written insurance policies on investors holdings. Then the U.S. House of Representatives initially rejected Treasury Secretary Henry Paulson s $700 billion plan to rescue troubled financial institutions.

«When we are panicked we misread signals, we misread mild threats as catastrophic threats and we become unduly conservative, says Shefrin, author of a 2000 paper, «Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing.

Thats one reason why, even as the Fed made $1 trillion available to banks, lending fell off a cliff. Borrowing by U.S. consumers unexpectedly declined by $7.9 billion in August, the first drop in more than a decade.

`Being More Careful

«Theres a lot of fear out there and theres a lot of worry, says C.R. «Rusty Cloutier, president and chief executive officer of MidSouth Bancorp Inc. in Lafayette, Louisiana. «Theres no question were being more careful in making loans.

The cost of issuing commercial paper. or short-term business loans, reached the highest level in eight months this week, squeezing companies, banks and public institutions that rely on the market to raise cash for expenses such as payroll. Combined with the pullback in bank lending, the commercial-paper freeze threatens to choke the economy.

That forced the Fed to announce on Tuesday, for the first time, that it would make loans to private companies, accepting commercial paper as collateral. Even this wont bring a quick end to the crisis, says 94-year-old Seth Glickenhaus. who was a messenger at Salomon Brothers when the stock market crashed on Black Tuesday in 1929. Today he manages $1.8 billion as chief investment officer of Glickenhaus & Co. in New York.

`Constructive Things

«There is a business cycle, he says. «The mere fact the government does constructive things doesnt make it go away.

Charles Geisst. a finance professor at Manhattan College in Riverdale, New York, sees a parallel to 1932, with credit markets bad and the stock market falling just ahead of the presidential election that put Franklin D. Roosevelt in the White House.

«But Im not sure anyone is FDR this time, says Geisst, author of «Wall Street: a History, who puts the possibility of another Great Depression at 50 percent. «I dont think either candidate has a clue what theyre dealing with here. This is more than a political problem thats going to blow over.

When experts and authority figures are uncertain, its especially crippling, says Paul Slovic, a professor of psychology at the University of Oregon in Eugene and founder of Decision Research. which investigates decision making and risk. «It makes people feel vulnerable and leads to greater anxiety, he says.

Bank Holiday

Within days of his inauguration, Roosevelt declared a bank holiday and held the first of his «fireside chat radio addresses to try to reassure Americans. In the days after Lehman and AIG melted down last month, President George W. Bush was nearly silent, uttering a total of 160 words about the worst financial crisis since Roosevelts time.

Another large component of fear is ambiguity, psychologists say. Investors simply dont know what is going on, making them even more anxious. Faced with an unfamiliar situation, humans, like other animals, retreat into «fight or flight mode, Shefrin says.

Its simply going to take time for investors fears to subside. With asset prices plunging, greed will eventually make a comeback.

Even today, stocks rebounded in Asia and Europe after South Korea and Taiwan cut interest rates following the concerted action by the Fed and others. The MSCI World Index added 0.9 percent to 1,013.09 at 8:55 a.m. in London. The index slumped 15 percent in the previous five days.

Doing Better

«An important aspect of greed is to avoid a situation where others are doing better than you because you remained conservative, say Baruch Fischhoff. a cognitive psychologist at Carnegie Mellon University in Pittsburgh who studies decision making.

Some investors are concerned about not being conservative enough, says Stefan Greenberg, a managing director at Lenox Advisors in New York, which counsels high net-worth individuals. His clients are calling to ask if their money-management firms are still solvent and whether they should sell their holdings, moving 100 percent into cash.

«We hear a lot of emotion, we hear a lot of fear Greenberg says. He is urging clients not to liquidate their portfolios.

«Of course theres panic, he says. «The next few months will take a strong stomach.

To contact the reporters on this story: Matthew Benjamin in Washington at Mbenjamin2@bloomberg.net Michael McKee in New York at mmckee@bloomberg.net

To contact the editor responsible for this story: Chris Anstey at canstey@bloomberg.net