At a time of great turmoil in financial markets, we revisit this October 1989 article by David Blake, which considered whether there was a rational explanation for why markets collapsed
Was the world stock market crash of 1987 a rational response to events, or was it the outcome of an irrational attack of panic? This was the question posed by David Blake, in his 1989 article. Blake highlighted many of the speculative bubbles in history – the Tulip Bulb Craze of the 1930s, the South Sea Bubble of the 1720s, and the Great Crash of 1929, to name a few.
He questioned whether the 1987 crash could be explained as a speculative bubble, caused by irrationality, or whether it was caused by rational behaviour from investors, as supporters of the efficient market hypothesis were suggesting. Three explanations of rational behaviour were posited: bad news theory, in which bad news led to an increase in perceived market volatility and price fall; the fear of market failure theory, where inadequately capitalised market makers were unable to stabilise a volatile market; and the excess hedging theory, which argued that the mechanical selling behaviour of portfolio insurers induced the crash.
Blake suggested that it was possible that the crash occurred for different reasons at different places. For example, in the US, excess hedging theory, where many institutional investors were using portfolio insurance, could be applied. In Hong Kong, the fear of market failure theory seemed the most plausible explanation, while London was the best example of a speculative bubble.
While there was little to do to legislate against panic and speculation, Blake argued that there were clear lessons to be learnt from rational explanations for the crash. Market makers had to be adequately capitalised. Excessive volatility should be reduced by government interventions. And finally, the quality of information in the marketplace should be improved.