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

TL;DR

This paper demonstrates that the classical economic paradigms of the invisible hand and rational agents can explain market bubbles and crashes when considering intermediate market aggregations and agent anticipation, challenging the view that these paradigms are outdated.

Contribution

It introduces a simple sociophysics-based model showing how rational market behavior and the invisible hand can generate bubbles and crashes through elasticity in market efficiency.

Findings

Market elasticity due to agent anticipation causes spontaneous bubbles.

Bubbles are rationally founded and lead to crashes when elasticity limits are exceeded.

The model suggests rationality alone cannot prevent bubble-crash phenomena.

Abstract

The substantial turmoil created by both 2000 dot-com crash and 2008 subprime crisis has fueled the belief that the two classical paradigms of economics, which are the invisible hand and the rational agent, are not 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 including the making of bubbles and their subsequent crashes. In so doing, an elasticity is discovered in the market efficiency mechanism due to the existence of agents anticipation. This elasticity is found to create spontaneous bubbles, which are rationally founded, and at the same time, it provokes crashes when the limit of elasticity is reached. Although the findings disclose a path to put an end to the bubble-crash phenomena, it is argued to be rationality not feasible.