In the month to date, stock markets in the US and Europe have declined by more than a quarter. In Asia they have fallen by slightly more. And with these declines has come a surge in stock market volatility.

Why is it happening? Does it matter to anyone except the traders shown slumped or shouting on television? And is this any rational way to run an economy?

Perhaps surprisingly, the answers are fairly straightforward. And the main lesson to be drawn is not that capital markets are inherently dangerous and destabilising. It is rather that they can help to protect people from future risks that were disastrously overlooked in the long build-up to today's financial crisis.

Stock markets have been collapsing for three main reasons. First, in more stable economic times, investors often employed a practice known as the “carry trade”. This meant borrowing in a currency with a very low interest rate - typically the yen - and investing the money in higher-yielding markets (Australia and New Zealand are good examples). As interest rates have been slashed throughout the developed world, this trade has become much less attractive.

Secondly, the crisis has exacted a heavy toll on hedge funds. These are like upmarket mutual funds for very wealthy private investors. They differ from, say, pension funds or unit trusts in two main ways. They can borrow to invest (known as leverage); and they can sell stocks that they do not own, in the hope that the price will fall and they can buy the stock back at a profit (known as short-selling). This means that hedge funds are often better placed to take an opposite position to conventional investment fashion than funds with a more conventional mandate.

Yet with neither justice nor logic, hedge funds have suddenly assumed the role of villain, according to tabloid mythology of the credit crisis. More seriously, regulators have curtailed their capacity to sell short. This is misguided. It is contributing to a flood of redemptions from hedge funds - which requires the funds to sell their assets.

Thirdly, and most important, investors are considering the economic outlook and concluding that there are immense risks to their future wealth. The value of any financial asset depends on how much cash it will generate for an investor in the future. In the case of a bond, the cash flows are the stream of future interest payments. In the case of a stock, they are the stream of future dividends paid out of corporate earnings. To work out what those cash flows are worth now, you have to apply a discount rate to your expectations for the future payments. A dividend payable in 2010 is less valuable to an investor now than a dividend paid in 2008, because it is less certain - so you have to apply a higher discount rate it to work out its value today.

Quite suddenly, the risk to the world economic outlook has ratcheted up. Investors see bad data and the collapse of leading banks, and worry that a cyclical economic downturn might become a depression. The risk of a seriously nasty outcome means that companies' future earnings are less certain. So sharp falls in stock prices, and the volatility of stock markets, are far from irrational. They are a signal - not a cause - of the underlying stresses in the world economy.

How far does this matter to the ordinary consumer and saver? It matters because most of us have money tied up in pension funds, which are invested, to a greater or lesser extent, in the stock market. The only sensible course to take is to regard investing as a long-term discipline. Investment returns become less volatile on average - and hence less risky - over longer time horizons.

And yes, financial markets are a valuable feature of a modern economy. They put companies who need money, and can use it productively, in touch with people who have money, and hope to boost their financial returns by investing it.

Is this not a trite conclusion, given all that has happened? No, it is not. The ructions that have engulfed the Western financial system come down to many things - but they started in the US housing bubble. The housing market in the UK has also frozen up. Houses are a huge investment for most of us - yet are terribly difficult to trade.

Robert Shiller, a Yale economist, has recently proposed a remedy in an outstanding short primer, The Subprime Meltdown. He argues that creating derivatives markets in house prices would help to tame the cycle of boom and bust. Sceptical investors could express that view in more immediate ways than selling their own homes. Housebuilders would note the expected price declines signalled by the market, and scale back their building activities.

Shiller's idea is plausible. It illustrates how financial markets need not be the casino or bearpit of popular criticism. Investment is above all about efficiently managing risk. Investors can spread their risk by diversifying their portfolios across stocks and asset classes. Financial markets also enable businesses to hedge against risks. These are valuable disciplines, and they can help us in future. As Shiller envisages, they might even correct the most damaging distortion in our economy: the fascination with bricks and mortar, to the detriment of making things and providing services.

Oliver Kamm is a Times leader writer and former investment banker

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