October 13, 2008
One Complaint with Partnoy
Posted by Mike Guttentag

Professor Frank Partnoy should be applauded for presciently considering many of the topics that the recent financial crisis has brought to the forefront.  In one of his articles, “Why Markets Crash and What Law Can Do About It,” Partnoy implicitly assumes that there are only two plausible reasons for a market to crash: either a market can crash as the result of a rational response to new information, or a market can crash as the result of a market failure.  The analysis of the October, 1987 crash in my previous posts reveals that Partnoy’s presumption about what can cause a market crash, though widely accepted, is incorrect.

Partnoy begins his analysis with a review of the Efficient Market Hypothesis (EMH), which posits that stock prices generally reflect available information.  As Partnoy correctly observes, when markets crash, the price changes are often so substantial that they cannot be explained by the sudden availability of new information (or by minor deviations from the EMH).  The October, 1987 crash provides a nice case in point.  The stock market dropped 22% in one day with relatively little new information.  Perhaps the market did fall that day for reasons that can be explained by behavioral psychology and cognitive errors, as Partnoy concludes.  But there is a third possibility as well, which Partnoy does not consider.

The problematic step in Partnoy’s analysis comes when he equates the EMH with the claim that “changes in prices should be essentially random responses to the revelation of new information” (p. 748).  The mistaken implicit assumption here is that prices are likely to be relatively stable in the absence of either new information or a market failure.  But the use of portfolio insurance in 1987 suggests a third way in which prices can change dramatically.  If the demand for equities is upward sloping in some price ranges, then two quite distinct equilibrium points might exist even without the introduction of new information.  In fact, there is good reason to believe that it was a move from one viable price equilibrium (with holders of portfolio insurance fully invested) to another viable price equilibrium (with holders of portfolio insurance largely divested) that triggered the market crash on October 19, 1987.  Just because share prices dropped by 22% on October 19 without dramatic new information (or rose 11% today!) does not mean that the EMH was violated.

The challenge presented here to Partnoy’s presumption that market crashes must be caused by either new information or a market failure is not simply a matter of semantics.  Recognizing that markets can crash, and yet be both informationally efficient and properly functioning, is crucial to crafting an appropriate regulatory response.

In challenging one aspect of Partnoy’s argument I do not want to diminish the many excellent points Partnoy makes in his article.  First, Partnoy is one of the few authors to acknowledge and directly address the significance of the October, 1987 crash (p. 747).  Partnoy also does a nice job of addressing and dismissing, as irrelevant for practical purposes, the rational bubble literature (p. 750).  Finally, while a market crash caused by the presence of multiple equilibriums would not be the result of a market failure, there is certainly something odd about the preferences revealed by the widespread use of portfolio insurance.

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