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Why Markets Crash and What Law Can Do about It

Frank Partnoy

University of San Diego School of Law

This article addresses the question of why financial markets crash and proposes new rules to prevent or ameliorate the effects of crashes. I define a market "crash" as a sudden and widespread downward movement in asset prices. I describe the importance of market crashes to real economic growth and their relationship to efficient market theory. I explain the market failure rationales for crashes, including theories of investor cognitive error, moral hazard, and information asymmetry. I then analyze the role of law in encouraging an environment of trust in financial markets. I am critical of recent finance studies explaining the correlation between strict corporate governance rules and real economic performance. I attempt to explain how efficient legal rules can create incentives for widespread, public ownership by non-controlling minority shareholders, and conversely how inefficient legal rules may lead to a predominance of family-controlled firms. I also am critical of recent proposals for regulating markets to prevent crashes, including self-regulation, creation of a new so-called "global architecture," various kinds of capital controls, and mechanisms for establishing a lender of the last resort. In place of the existing approach to financial market regulation, I propose a new framework for analyzing law as a product that can be traded, and suggest how countries may opt into competing regulatory jurisdictions to prevent market crashes. I argue that regulatory competition already has resulted in issuers opting out of inefficient regulatory jurisdictions based on comparative advantage, and suggest mechanisms, including a "public poison pill," to encourage broad distribution of shares in countries in which most large firms are family-controlled. I also propose a system of short-term market insurance to protect investors from sudden and widespread downward movements in markets. In such a system, the government would act as a "stock buyer of last resort," instead of as a lender of last resort (the current U.S. policy), to support prices at some specified level in the event of investor panic.

I conclude with an application of these arguments to the recent crisis in Asia. I explain how the Asia crisis fits the model described above, and describe the failures of the U.S.-led response. In particular, World Bank and International Monetary Fund policies solved few problems and created many more, particularly by increasing the moral hazard associated with implicit guarantees to those investing in emerging markets. Perhaps most important, policymakers ignored the importance of family-dominated firms in the crisis.

Number of Pages in PDF File: 80

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Date posted: November 26, 1999  

Suggested Citation

Partnoy, Frank, Why Markets Crash and What Law Can Do about It. Available at SSRN: http://ssrn.com/abstract=183473 or http://dx.doi.org/10.2139/ssrn.183473

Contact Information

Frank Partnoy (Contact Author)
University of San Diego School of Law ( email )
5998 Alcala Park
San Diego, CA 92110-2492
United States
619-260-2352 (Phone)
619-260-4180 (Fax)
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