Bounded strategic reasoning explains crisis emergence in multi-agent market games

TL;DR

This paper demonstrates that bounded rationality and strategic reasoning among agents can naturally lead to market crises and stylized facts like fat tails and volatility clustering without external shocks.

Contribution

It introduces a model showing endogenous crisis emergence driven by bounded rational agents, challenging traditional equilibrium-based market theories.

Findings

Bounded rationality causes endogenous market crises.

Fat tails and volatility clustering explained by agent diversity.

Stylized facts arise without external news, from agent interactions.

Abstract

The efficient market hypothesis (EMH), based on rational expectations and market equilibrium, is the dominant perspective for modelling economic markets. However, the most notable critique of the EMH is the inability to model periods of out-of-equilibrium behaviour in the absence of any significant external news. When such dynamics emerge endogenously, the traditional economic frameworks provide no explanation for such behaviour and the deviation from equilibrium. This work offers an alternate perspective explaining the endogenous emergence of punctuated out-of-equilibrium dynamics based on bounded rational agents. In a concise market entrance game, we show how boundedly rational strategic reasoning can lead to endogenously emerging crises, exhibiting fat tails in "returns". We also show how other common stylised facts of economic markets, such as clustered volatility, can be explained due to agent diversity (or lack thereof) and the varying learning updates across the agents. This work explains various stylised facts and crisis emergence in economic markets, in the absence of any external news, based purely on agent interactions and bounded rational reasoning.