One striking aspect about the public debate in the U.S. on the financial crisis is the extent to which the parallel crisis in Europe has largely been ignored. Some of the European crisis revolves around investments in U.S. asset-backed securities or exposure to U.S. financial institutions. But much of it is not. European financial institutions got themselves in plenty of trouble on their own with bad investments in real estate in Europe.

Which strongly suggests that the best characterization of the current financial crisis is that there was a bubble caused by excessive money (including, but not limited to, money from China and the Gulf States), chasing too few opportunities that could generate sustainable profits. Not a novel insight by any means.

But the bubble explanation often leads to some facile responses that together suggest law doesn't have much to say on the topic. I am hard at work on a book on bubbles and financial regulation (on sale 2010 or 2011--can't miss investment! Call Routledge now and place your order!), which seems professionally hazardous given that I routinely encounter some of the same suspicious reactions. Here are some of the myths on bubbles that I am bent on busting:

1. The current crisis is a "Black Swan" event: personally, I hate the "black swan" metaphor. It suggest that the crisis was some Act of God that no one could have predicted, rather than a man-made event which several policymakers and scholars did warn of. Moreover, I always find it darkly amusing that "hundred year storms" tend to happen a lot more often than every hundred years.  There are a lot of parallels between this crisis and previous financial crises -- including cheap credit and inexperienced investors (home buyers, and possibly even many institutional purchasers of asset-backed securities and derivatives).

2. Conversely, everyone knew it was a bubble: See bias, hindsight. (There is also a tendency to see a bubble now everywhere without really defining terms.  See bias, availability).

3. We need to know with absolute certainty whether a bubble exists before regulators can take corrective action: economists engage in raging debates over whether historical periods were bubbles or not - i.e. whether prices of an asset like tulip bulbs diverged from their fundamental value. But uncertainty over whether there is a divergence from fundamental value shouldn't paralyze regulators from taking various steps during a booming financial market for several reasons including:

a. First, many of the dynamics of a boom and bust market have negative consequences -- epidemics of fraud, threats to the solvency of financial institutions -- regardless of whether prices exceed fundamental value.

b. Second, many central bankers and economists are more comfortable identifying bubbles under uncertainty than recent Federal Reserve Chairmen (link). There are classic warning signs-an influx of new, unsophisticated investors, cheap credit etc.  

4.   If it was a bubble, there is nothing to do; investors are just irrational. There are a number of things that can and do work, not to cure the irrationality of investors, but to restrict the amount of credit/leverage/liquidity that fuels a bubble.  A host of financial regulations play a role, directly or indirectly, in affecting the amount of credit that flows to asset markets.  Conversely, "deregulation" (see below for what this term means) can also affect credit to asset markets often without policymakers fully understanding that will be the effect.

5.   Laws can stop bubbles: Given the historic recurrence of investment manias and the experimental evidence, it would be quixotic to prevent bubbles. But we can mitigate their severity. And just because evidence shows that some regulations can't prevent bubbles, doesn't mean that the absence regulation wouldn't make them worse.

6.   Deregulation is to blame: Actually, there is a pretty clear pattern of deregulation preceding “bubble" periods. But it is important to see that "deregulation" means more than just repeals of statutes. Deregulation also could take the form of (a) under-enforcement of existing regulations, (b) refusal by regulators to deal with growing threats to financial markets, and (c) sometimes, active stimulation of market booms by regulators (like the South Seas episode or several aspects of federal mortgage policy in the current crisis).

I won't attempt to boil down the rest of my book into bullet points, but let me throw down a final proposition to stir up debate:

The ur-purpose of both securities regulation and banking law often gets lost. The most important securities and bank laws result from financial crises. I argue prevention of financial markets from periodically destroying themselves remains the ur-purpose of these fields. Everything else is secondary.

For those of you interested in the topic of preventing market crashes, Michael Guttentag (Loyola-LA) will be giving a paper on the topic at the AALS- Securities Regulation Section in New Orleans on Sat. Jan. 9th.

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