What got me thinking about this was this excellent Mark Thoma post saying the key missing ingredient in the current financial markets is reliable information about risks, and speculating about whether "trust" could be a short-term substitute.  The "efficient market" hypothesis, the idea that the only requirement for the smooth functioning of markets is good reliable information, comes through implicitly if not explicitly in many of the comments.  My view is that, while good reliable information is important, it is not sufficient.  Other than religious leaders, I can't think of any group more apt than economists to push magic bullet solutions for complex problems.  If they were medical professionals we would happily call them quacks. 

Ezra Klein quotes Henry Blodgett and adds some comments of his own here about conflicts of interest and collective action and the inability of the market itself to correct a collective action. 

At the height of the bubble, there was so much money to be made that any firm that pulled back because it was nervous about risk would forsake huge short-term gains and lose out to less cautious rivals. The fact that VaR didn’t measure the possibility of an extreme event was a blessing to the executives. It made black swans all the easier to ignore. All the incentives — profits, compensation, glory, even job security — went in the direction of taking on more and more risk, even if you half suspected it would end badly. After all, it would end badly for everyone else too. As the former Citigroup chief executive Charles Prince famously put it, “As long as the music is playing, you’ve got to get up and dance.” Or, as John Maynard Keynes once wrote, a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”

From this fine Joe Nocera article about the rise of Value at Risk ("VaR") modeling in the financial industry.  Update 1/4/09 at 10:00 p.m.: This article is discussed here on Mark Thoma's blog.  Among the points made is this one:  Not only are prices not normally distributed in the past (a key assumption in the VaR models) but events can make futures vastly different from pasts--for example, the Bull's won-lost record vs. the Knicks was not the same before and after the Bulls drafted Michael Jordan.

Some academic research finding support for the hypothesis that individual investors are inclined to follow the herd, by an adjunct professor at Columbia Business School and former investment banker, is reported on Mark Thoma's blog here.  Just posted, but there are likely to be a lot of good comments. Update 1/1/09 at 9:30 p.m.:  Indeed there were, especially the rejoinder this morning by author Eric Schoenberg.  He points out that investing and not investing both have risks and that while not investing may have a less catastrophic potential outcome, the less-than-catastrophic outcome is highly likely to occur.

"Leverage cycles happen not because people are stupid, or because they ignore danger signs. It’s in the nature of competition to drive leverage to unsustainable levels, whereupon it collapses, with various effects," according to David Warsh discussing the work of John Geanakoplos. 

Geanakoplos offered a clear and straightforward explanation of the path by which the world had gotten into the current mess. He shed fresh light on the halting steps now being taken to get out of it.

 

For at least a century, he noted, economists have been accustomed to thinking of the interest rate as the most important variable in the economy – lower it to speed things up, raise it to slow them down. Yet especially in times of crisis, collateral demands – alternatively, margin requirements, loan-to-value ratios, leverage rates or “gearing” – become much more important.

 

Everybody knows that when interest rates go down, prices rise. Less widely recognized is that when margin requirements go down – say, the down payment on a house – prices rise too, often even more. Without some form of control, leverage becomes too high in boom times, and asset prices soar disproportionately. When they crash, leverage crashes with them, and then prices suddenly are too low. This is the leverage cycle, Geanakoplos says, and the current crisis is the result of a particularly virulent specimen. Intervention can mitigate its worst effects.

 

Central banks, therefore, should rethink their priorities. The Fed should learn to manage system-wide leverage, he said, reining in on it in ebullient times and propping it up in anxious times, in order to prevent the worst outcomes. Leverage cycles happen not because people are stupid, or because they ignore danger signs. It’s in the nature of competition to drive leverage to unsustainable levels, whereupon it collapses, with various effects.