It is received wisdom that market crashes occur as a reaction to negative news about the economy or companies' earnings outlooks. But in a recent article in New Scientist, academics say crashes are not the result of specific events immediately beforehand, as most people believe, but the unstable build-up of debt.

A new generation of financial market simulations shows that bubbles, at least in theory, can be prevented before conditions reach a point where a crash is inevitable.

Stefan Thurner, head of the Complex Systems Research Group at the Medical University of Vienna, and academics in the US have produced a computer model that mimics the behaviour of hedge-fund managers, banks and small investors. Each operated with their own goals and behaviours.

"The model's hedge funds try to identify momentarily mispriced securities and make a profit by buying or selling in the expectation that the price will return to a realistic value in the future," he says. "As in the real world, they leverage their investments by borrowing from the banks."

The conventional view is that markets are almost always in equilibrium, reflecting an overall balance of economic forces. Market values change only when there is new information about the earnings outlook for a company or economic growth rates. "Given how rumours drive markets up and down, and the way investors flock like sheep and follow the words of various gurus, this is clearly unrealistic," New Scientist comments.

The new modelling shows that markets can reach a state that is like an avalanche waiting to happen. And, perhaps less surprisingly, the modelling finds that when there is a huge build-up of debt, the conditions for the avalanche to occur become more acute.

Didier Sornette, an econophysicist at the Swiss Federal Institute Of Technology in Zurich, told the magazine: "All bubbles I have studied have been associated with increasing access to easy money, whether it is lower margin requirements, lower interest rates, more foreign investments and so on."

With no borrowing, a fund manager can only lose investors' money. But as leverage increases there's the risk that it will lose money borrowed from the bank. The threat of bank failures can cascade through the market and the cascading can occur very quickly.

The modelling shows that a certain level of borrowing appears to be all right. But after so much leverage has spread through markets "it becomes overwhelmingly likely that a single chance failure will send waves of trouble through the entire market", New Scientist says.

"Increasing levels of credit create stronger links between market players, heightening the chance that the failure of one can put an unsustainable burden on others, triggering further failures." In other words, a chain reaction.

In the past 15 years, investors in most developed countries have gone on one of the biggest, if not the outright biggest, debt binge with access to margin loans, instalment warrants, equity credit loans, geared share funds and so on - much of it funded on the back of low interest rates and rising house prices.

Debt is a precursor to a crash but almost anything can trigger the avalanche once the system is at the tipping point. The academics say one of the most obvious ways of halting the growth of these bubbles before they come crashing down is to limit the availability of credit in the first place.

Of course, that is what central banks, such as the US Federal Reserve, try to do. But it usually acts too late, only raising interest rates when the market has already become overheated. The Fed treads carefully, wary that if it increases rates too much or too quickly it could bring the market crashing down instead of engineering a soft landing.

Sornette says new approaches are needed: "The natural reaction is to update and up-scale regulation and supervision but this has repeatedly failed to ensure even medium-term stability in the past. If we don't address the problems, there's absolutely no doubt that other extreme crises will occur in the future."

Moral hazard

There is little doubt that moral hazard is one of the biggest preconditions for the sub-prime crisis.

Moral hazard - identified in standard economics - is where someone behaves recklessly because they know somebody else will bear the risks (and losses) if anything goes wrong.

There are big financial incentives to encourage people to act for their own short-term profit while shunting the longer-term risks to someone else, such as an employer, a company's shareholders or its customers.

New Scientist highlights the role of brokers in the United States selling sub-prime mortgages as one such example.

Brokers collected commissions on the mortgages they sold to low-income borrowers with poor credit histories and no deposits.

But since the brokers were not lending their own money, it was risk-free for them.

The investment banks bought these mortgages and bundled them into collateralised debt obligations, which were then sold to other institutions and small investors.

Once again, the risks were shunted off to someone else.

As we now know, it was the rapid rise in defaults on repayments on these sub-prime loans that triggered the credit crunch in the middle of last year.

In the boom times, senior executives of listed companies do very well out of incentive packages consisting of short-t and long-term incentives. However, the longest of these is only up to three years.

And plenty of chief executives who were paid a fortune in the good times were also paid a fortune to leave after destroying shareholder value.