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A Theory of Financial Market Instability Even Under Perfect Conditions: Bubbles and Crashes in Rational Belief Equilibrium

This research project seeks to develop a theory of how bubbles and crashes can arise even when all agents are rational, informed, and trading in perfect markets.

The theory of bubbles and crashes that breaks the minimum possible number of the assumptions behind efficient market equilibrium is the theory of rational expectations bubbles as developed by Blanchard and Watson. These bubbles can exist under practically no modifications to the standard general equilibrium model of a “perfect” economy. This achievement, however, comes at a cost. While there have been subsequent refinements, the theory of rational expectations bubbles still cannot explain why or how such bubbles originate. Rational expectations bubbles can only exist if the asset in question has been mispriced from its very inception. This project establishes bubbles and crashes as inherent features of economic systems, providing a rigorous counterargument to “market fundamentalism,” i.e., the idea that such instabilities only result from market failure and shall be resolved by moving ever closer towards the ideal market. To achieve this goal, the project integrates tools and concepts from what is sometimes called “econophysics” in a general equilibrium framework under rational beliefs.