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Regulation Revisited

NEW YORK – We are in the midst of the worst financial crisis since the 1930’s.ampnbsp;ampnbsp; The salient feature of the crisis is that it was not caused by some external shock like OPEC raising the price of oil.ampnbsp; It was generated by the financial system itself.

This fact – a defect inherent in the system – contradicts the generally accepted theory that financial markets tend towards equilibrium and deviations from the equilibrium occur either in a random manner or are caused by some sudden external event to which markets have difficulty in adjusting.ampnbsp; The current approach to market regulation has been based on this theory but the severity and amplitude of the crisis proves convincingly that there is something fundamentally wrong with it.

I have developed an alternative theory which holds that financial markets do not reflect the underlying conditions accurately.ampnbsp; They provide a picture that is always biased or distorted in some way or another.ampnbsp; More importantly, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect.ampnbsp;

I call this two-way circular connection between market prices and the underlying reality ‘reflexivity’.ampnbsp; I contend that financial markets are always reflexive and on occasion they can veer quite far away from the so-called equilibrium.ampnbsp; In other words, financial markets are prone to produce bubbles.ampnbsp;