Today’s financial crisis, triggered by the collapse of the housing bubble in the United States, also marks the end of an era of credit expansion based on the dollar as the international reserve currency. It is a much bigger storm than any that has occurred since the end of World War II.
To understand what is happening, we need a new paradigm. It is available in the theory of reflexivity, which I first proposed 20 years ago in my book The Alchemy of Finance . The theory holds that financial markets do not tend towards equilibrium. Biased views and misconceptions among market participants introduce uncertainty and unpredictability not only into market prices, but also into the fundamentals that those prices are supposed to reflect. Left to their own devices, markets are prone to extremes of euphoria and despair.
Indeed, because of their potential instability, financial markets are not left to their own devices; they are in the charge of authorities whose job it is to keep the excesses within bounds. But the authorities are also human and subject to biased views and misconceptions. And the interaction between financial markets and financial authorities is also reflexive.
Boom-bust processes usually revolve around credit, and always involve a bias or misconception – usually a failure to recognize a reflexive, circular connection between the willingness to lend and the value of the collateral. The recent US housing boom is a case in point.