A stray thought:
Usually when demand increases for something, that drives the price up, which decreases the demand until the price stabilizes.
But this stabilizer seems to work in the wrong direction in financial markets: When demand increases for a stock, that drives the price up, which
*increases* demand -- at least until it is obviously overpriced. When demand decreases for a stock, that drives the price down, which *decreases* demand, inducing more people to sell.I've heard this notion expressed as follows: "Why is it that when Macy's holds a sale, people rush to buy; but when Wall Street holds a sale, people rush to sell?"
So if I'm right, investor behavior is a natural market destabilizer: Price changes feed back into investor behavior, which tends to push prices in the same direction in which they were already moving. More evidence for this phenomenon is that when stock prices decline, there is invariably a huge outflow from stock mutual funds to bond mutual funds.
In general, when a feedback loop causes instability, reducing the amount of feedback will reduce the instability, often dramatically. When a PA system starts to squeal, turning down the volume just a tiny bit will usually stop it. Which suggests that one way to increase stability in financial markets is to find a way to influence investor behavior in general -- and it probably doesn't need to be very much of an influence.