SYNOPSIS: Casts aside lingering belief in market rationality as the Nasdaq plunges in the background

If you are one of those people who, despite all the evidence, retain some lingering illusions about the rationality of financial markets, yesterday should have cured you. And yesterday's events also proved that worries about the growing practice of buying stock on margin -- in effect, borrowing in order to speculate -- are completely justified.

It has taken economists a long time to accept the idea that financial markets are systematically too volatile. It was almost 20 years ago that Robert Shiller, whose important new book, "Irrational Exuberance," has made a couple of previous appearances in this column, produced what he thought was an ironclad argument against the then-dominant "efficient market" theory of stock prices.

According to that theory, movements in the stock market should always reflect genuine news about future earnings. But Mr. Shiller showed that actual stock prices fluctuated much more than any possible rational forecast of prospective profits; he thought that this "excess volatility" result would settle the point.

Of course, it didn't. Efficient-market theorists (including some of the future principals of Long Term Capital Management -- the hedge fund that collapsed in 1998, when markets did what they weren't supposed to) defended their ground, producing elaborate statistical critiques of Mr. Shiller's calculations. Yet over the years events gradually eroded economists' faith in market rationality.

The most famous case was, of course, the 1987 stock crash, during which Mr. Shiller had the presence of mind to carry out an instant survey of investors. That survey discredited in advance all the supposedly rational explanations for the crash concocted in the weeks following, because it showed that the only reason any significant number of investors gave for selling stocks was -- surprise! -- that prices were falling.

But if that wasn't enough to convince you, yesterday surely must have done the trick. If you were lucky enough to have missed the action you were spared a nauseating ride. At one point the Nasdaq was down 575 points -- that is, around 13 percent. But by the closing it had recovered 500 of those points.

Was there any real news to explain all this turmoil? True, there were developments in the Microsoft case. But it is hard to see how that news could have justified even the fall in the price of Microsoft itself, let alone the pounding taken by the stocks of companies that one might have expected to be celebrating the new weakness of the Evil Empire. Anyway, the timing was all wrong. The lack of a settlement was old news by Monday morning; the formal verdict by the judge delivered Monday afternoon contained few surprises, and anyway had been fully digested by yesterday morning.

So the wild swings in the market were, as Mr. Shiller could have told you, mainly self-generated: the same people who frantically bought tech stocks over the last couple of months, because the prices were rising, sold them frantically over the last two days because the prices were falling. Some of those people were naïve individual investors who panicked (you mean these things can go down?) or, worse, were forced into sales because they had bought on margin. Indeed, margin calls probably played the same role in yesterday's market that automatic sell programs played back in 1987.

But does this craziness do any harm? Or is it all audio and video, signifying nothing? Well, many individuals, especially those who had speculated on margin, have suffered losses they can never recover. And this level of volatility has got to be bad for business planning, perhaps even a threat to the stability of the real economy.

For some time now Mr. Shiller and others have been pleading for action to limit market volatility. At the very least, surely, we should impose limits on margin buying; I admit to being completely baffled that nothing has been done over the past year, as margin debt has soared. And it's now past time to take a serious look at other proposals, like that of subsidizing the creation of futures markets in dividends (which could help ground stock prices in reality).

When things are going well there is a strong tendency to suppose that financial markets can take care of themselves. Well, they can't.

Originally published in The New York Times, 4.5.00