One of the consequences of the subprime meltdown and subsequent stock market decline this past week is certain: there will be a regulatory response.  If past is prologue, there is also a good chance that regulatory responses will fail over the long term to the extent they are not based on a fundamental understanding of the underlying problems.

Over the next series of posts I offer a model that explains why markets crash.  This model provides a way to sift through the various explanations offered as to what “caused” this most recent “crash,” including speculative excess (on the high end), irrational fear (on the low end), too little liquidity, too much complexity, rampant fraud, not enough disclosure, and the explosion in credit derivative products.  I’ll show where each of these explanations falls short.  Only with this work done is it possible to set out the relatively short and simple list of appropriate regulatory responses.

I start this series in the next post with a discussion of the stock market crash on October 19, 1987 (still the largest single day percentage drop on record).   The dynamics that led to the crash in 1987 are surprisingly transparent, and understanding those dynamics provides a window into other crashes (including the Crash of 1929, and what happened in the equity markets this past week). 

Two endnotes:  First, I only deal with financial market crashes, so my analysis does not consider the interactions between financial markets and the underlying markets for goods and service.  In other words, I am not making any claims about how to regulate monetary policy or other macroeconomic levers.  I would note in this regard there is a fair degree of disagreement over the extent to which financial market are linked to real markets.  As evidence, one need only look at the competing editorials in today’s New York Times by Casey Mulligan and Paul Krugman.

Second, the perspective I take focuses primarily on the nature of the demand curve for risky assets, which I think is largely a microeconomics perspective.  So I hope to provide Gordon a third category of brave fools to disbelieve.

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