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The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact—that the defect was inherent in the system —contradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting. The severity and amplitude of the crisis provides convincing evidence that there is something fundamentally wrong with this prevailing theory and with the approach to market regulation that has gone with it. To understand what has happened, and what should be done to avoid such a catastrophic crisis in the future, will require a new way of thinking about how markets work.

Consider how the crisis has unfolded over the past eighteen months. The proximate cause is to be found in the housing bubble or more exactly in the excesses of the subprime mortgage market. The longer a double-digit rise in house prices lasted, the more lax the lending practices became. In the end, people could borrow 100 percent of inflated house prices with no money down. Insiders referred to subprime loans as ninja loans—no income, no job, no questions asked.

The excesses became evident after house prices peaked in 2006 and subprime mortgage lenders began declaring bankruptcy around March 2007. The problems reached crisis proportions in August 2007. The Federal Reserve and other financial authorities had believed that the subprime crisis was an isolated phenomenon that might cause losses of around $100 billion. Instead, the crisis spread with amazing rapidity to other markets. Some highly leveraged hedge funds collapsed and some lightly regulated financial institutions, notably the largest mortgage originator in the US, Countrywide Financial, had to be acquired by other institutions in order to survive.

Confidence in the creditworthiness of many financial institutions was shaken and interbank lending was disrupted. In quick succession, a variety of esoteric credit markets—ranging from collateralized debt obligations (CDOs) to auction-rated municipal bonds—broke down one after another. After periods of relative calm and partial recovery, crisis episodes recurred in January 2008, precipitated by a rogue trader at Société Générale; in March, associated with the demise of Bear Stearns; and then in July, when IndyMac Bank, the largest savings bank in the Los Angeles area, went into receivership, becoming the fourth-largest bank failure in US history. The deepest fall of all came in September, caused by the disorderly bankruptcy of Lehman Brothers in which holders of commercial paper—for example, short-term, unsecured promissory notes—issued by Lehman lost their money.

Then the inconceivable occurred: the financial system actually melted down. A large money market fund that had invested in commercial paper issued by Lehman Brothers “broke the buck,” i.e., its asset value fell below the dollar amount deposited, breaking an implicit promise that deposits in…