The invisible hand and the rational agent are behind bubbles and crashes

doi:10.1016/j.chaos.2016.03.011

Chaos, Solitons & Fractals

Volume 88, July 2016, Pages 209-217

https://doi.org/10.1016/j.chaos.2016.03.011 Get rights and content

Abstract

The 2000 dot-com crash and the 2008 subprime crisis have fueled the belief that the two classical paradigms of economics, the invisible hand and the rational agent, are not well appropriate to describe market dynamics and should be abandoned at the benefit of alternative new theoretical concepts. At odd with such a view, using a simple model of choice dynamics from sociophysics, the invisible hand and the rational agent paradigms are given a new legitimacy. Indeed, it is sufficient to introduce the holding of a few intermediate mini market aggregations by agents sharing their own private information, to recenter the invisible hand and the rational agent at the heart of market self regulation. An elasticity is discovered in the market efficiency mechanism due to the existence of an agent collective anticipation. This elasticity is shown to create spontaneous bubbles, which are rationally founded. At the same time, crashes occur at once when the limit of elasticity is reached. Plasticity can also be achieved through a combination of a crash with a sudden shift of the collective anticipation. Although the findings disclose a path to put an end to the bubble-crash phenomena, it is argued to be rationally not feasible. Bubbles and crashes are thus an intrinsic internal part of classical economics.

Section snippets

The invisible hand and the rational agent

In the last decades several crises in the financial world with subsequent heavy damages in the labor market and economy growth have put at stake the two classical paradigms of economics which are the invisible hand, the rational agent and their drive to associated equilibrium states [1]. Indeed, the substantial turmoil created by the 2000 dot-com crash and 2008 subprime crisis have shaken quite many economists and financial analysts leading them to believe that those classical two paradigms

Model and main hypothesizes

At the heart of market behavior in addition to the economical reality stands human behavior and to study human behavior stands sociophysics. What is sociophysics? It is the use of concepts and techniques from Statistical Physics to describe some social and political behaviors. It does not aim at an exact description of the reality but at singling out some basic mechanics which may be rather counter intuitive. Initiated more than 33 years ago [[24], [25]], it has started to become a main stream

The model

By definition a rational agent reaches the right decision, to buy or sell a given asset,upon the analysis of its individual private information combined with the common information available to everyone. However, its private information is piecemeal since the complete information which determines the actual corresponding fundamental value is not accessible at once to one person, being fragmented into many pieces of different contents and meanings. Accordingly some agents end up making the wrong

How it works

From last Section, the rationality of the agents combined with the market invisible hand results into the appearance of two regimes of market deficiency with the existence of an elasticity in the effect of market efficiency. While the aggregated private informations leads a buying or a selling trend, the current agents anticipation thwarts the efficiency to overcome the real signal reversing the trend direction. A bubble is formed. However, this thwarting can be implemented only within a fixed

Conclusion

Applying the sociophysics Galam model of opinion dynamics to marker dynamics we have been able to construct an efficient market using an invisible hand to aggregate individuals private information to have the fundamental price reflected in the making of the current price. The process is built on through a series of sequential local market aggregations of private information to turn a fuzzy initial signal leading to a probabilistic distribution of individual choices, onto a deterministic clear

Acknowledgment

I would like to thank J. V. Andersen, M. Ausloos, S. Stefani and G. Rotundo for useful discussions about finance.

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The invisible hand and the rational agent are behind bubbles and crashes

Abstract

Section snippets

The invisible hand and the rational agent

Model and main hypothesizes

The model

How it works

Conclusion

Acknowledgment

Physica A

Econ Lett

J Econ Theory

Phys Rev E

Physica A

The theory of moral sentiments (1759, 1st ed.)

Herd behavior, bubbles and crashes

Econ J

How the financial crash of october 1997 could have been predicted

Eur Phys J

An introduction to econophysics: correlations and complexity in finance

Endogeneous vs exogeneous shocks in complex systems: an empirical test using book sales ranking

Phys Rev Lett