Now is the time to be saying loudly, clearly and as often as we can that markets are not, never were, and never will be, efficient nor rational. One look at the present mess belies that central claim of markets and their proponents, that markets are efficient at allocating resources. We have been told ad nauseam that things must be "left up to the market". It is time to debunk this central myth of market economics.
The "rational" thing for investors to do just now would be to hold their nerve and not sell. If everyone did so the market would not fall. But that would require the co-operation of others and market operations, with their unequal, often winner-takes-all structures lead to competition not co-operation. That barrier to co-operation is in the mind.
Social psychologists have known for 40 years that the structure of a situation can determine people's attitudes, how they see others and their willingness to co-operate. Too many economic actors have been brought up on prisoners' dilemmas, game theory, and the belief that everyone should pursue their own individual self-interest (because that is how the market operates most efficiently and produce social good in this best of all possible worlds). Worse still, these economic actors assume everyone else thinks as they do and will be have selfishly, and so the chance of getting a co-operative effort started is reduced even further.
We have known from the start that banks needed to start lending to one another again, and that the same banks will suffer if the banking system fails (and the banks themselves seem to have understood this), yet they stubbornly declined to do so. They believed "we just can't until conditions change" but conditions never were going to change for as long as they took this attitude. This is what social scientists call a social trap. The better-known tragedy of the commons (whereby individuals selfishly take more than is sustainable from the common pot until that pot is used up) is a social trap, things people fall into because they do not realise what is going on or cannot see overall outcomes.
In a true market there are just individual decisions and we only realise there is a problem after it is happened because no one is looking out for society as a whole.
Then there are social fences - things that require an effort or cost, for example, trusting others, but no one is prepared to take the first step. "Someone will always default" is the objection, which becomes a self-fulfilling prophecy. How people behave depends on how they think others will behave. If everyone has the selfish, individualist mindset, then they assume others will default and want to get there first.
Judged even by the goals of economic actors (rather than society as a whole) the market is incapable of producing rational outcomes even when its own life depends on it. Judged by society's goals it fails further still and it does so because it is the perfect breeding ground for social traps, because it prevents co-operation and because society's values cannot be represented in monetary exchanges directed by selfish individualism and the profit motive. The idea that the common good will somehow magically arise from the unco-ordinated actions of selfish actors is a myth.