Taming Manias: On the Origins, Inevitability, Prediction and Regulation of Bubbles and Crashes

Abstract

Chapter Summary: We consider the recent financial crisis as an overlapping sequence of interdependent financial bubbles followed by their collapse. Governments and regulatory agencies have made it a prime goal to moderate future crises. Many attempts at financial, economic and social engineering are plagued by an “illusion of control” typical of complex systems for which we offer some suggestive mathematical models. The “illusion of control” presents a significant challenge to effective resilience engineering. Furthermore, control may not only yield no benefit, but at times may exact perverse new costs. We argue that some markets almost always; almost all markets sometimes; and economies in general are truly “complex systems” in a technical sense; that as such, they are intrinsically characterized by periods of extremity and by abrupt state-transition; that they spend much time in a largely unpredictable state, but on the other enter periods of pre-crisis when they are predictable. In consequence of a system phase (or regime) transition, we argue that the most extreme events - the most influential ones - are susceptible to (probabilistic) prediction. In light of this analysis, we offer a small number of perhaps counter-intuitive suggestions, for example, that many of the present interventions in the “liquidity crisis” are ill-advised and possibly dangerous - e.g., the widespread attempts to artificially stimulate consumption in the absence of precautionary reserves and in the presence of huge liabilities; as an example of real-world, large-scale resilience engineering we suggest that bubble-prediction should be a mainstay of financial regulation.

Keywords: financial bubbles, positive feedbacks, illusion of control, unintended consequences, dragon-kings, outliers, prediction, systemic instabilities

JEL Classification: G01, G17, G18