A stock-market collapse such as the one after the 2008 Lehman Brothers default is followed by more pessimistic assessments of the likelihood of future collapses in surveys and by lower price-dividend ratios. This column argues this reaction of expectations and asset prices can be explained by Bayesian decision theory. The key is to appreciate that market participants know little about the drivers of such crashes. They revise their beliefs and learn over time.
Policy Letter No. 14, 2011
