There are very good reasons why we are not allowed to yell “fire” in crowded theaters and other similar venues. Panic would be the natural response. There unlikely would be any orderly response despite the fact that most of us have gone through fire drills at one time in our lives.

Yet, economists continue to teach their students that their theoretical competitive markets are stable and should serve as the ideal for guiding a wide range of policy making despite the fact that the logic, based on assumptions underlying the model, is seriously flawed. The theory presumes that when a shock occurs, the adjustment process will take place in an orderly manner, and a new and predictable equilibrium will be restored quickly. However, given the assumptions of the model, namely, that everyone is equally well informed and no one possesses any advantage, it is logically impossible for stability to return without government intervention that constrains price movements and the magnitude, speed and order of entry and exit.

Economists continue to teach this model because if they admitted its fatal flaws, they would be left with little to anchor their models of markets and competitive behavior.

James Tobin, the great Yale economist, fully understood the problems, especially as they might arise in financial markets. As a result, he proposed that governments should introduce a tax on all financial transactions. The tax would be akin to throwing sand into the gears of a machine. That is, the tax would act like a regulator on engines to slow down the speed of adjustments in financial markets.

Most economists have criticized the so-called Tobin tax as an unnecessary constrain on the functioning of competitive financial markets. Unfortunately, these economists, while very well trained in math and the core of microeconomic theory, are not in the same intellectual league as Tobin; nor do they have the same intuition and understanding of human behavior.

While financial markets do not possess all of the characteristics of the competitive market ideal, there are a sufficient number of investors who are comparably positioned so that their actions might replicate the adjustment process assumed for competitive markets. At least, this is the theory.

But the behavior of the U.S. equity markets this past Thursday demonstrated that financial markets can be extremely volatile and unpredictable. When there are a number of investors with their own, but rather similar, computer-driven trading models, the possibility exists that all their computers could try to head to the exit at the same time. Somewhere in the data they scan and analyze, there was the equivalent of someone yelling “FIRE”. The sell orders kicked in followed by panic and fear on the part of those who did not understand what was happening.

The only thing surprising about the 20-minute shock on Thursday afternoon was that such events do not occur more frequently. The financial market meltdown in 2008 largely was the outcome of dramatic price changes for certain groups of assets, and the ensuing fear of banks to lend to anyone because they no longer had confidence in the pricing of these and related assets.

Financial markets react to shocks as Tobin feared – rapidly and dramatically. Without government intervention, financial markets can melt down.

If the investigation into what caused the hysteria on Thursday leads to the introduction of a Tobin tax, then it will be worthwhile. If it leads to new circuit breakers and other rules to constrain price movements and trading activity, it will still be worthwhile. But if the outcome will be no new rules or taxes, then the investigation will be a total waste of time, and we will be no better prepared for the “big one”!

The opinions expressed in this blog are personal and do not reflect the view of either Global Brief or the Glendon School of Public and International Affairs.