Let me state the two cardinal principles of my conceptual framework as it applies to thefinancial markets. First, market prices always distort the underlying fundamentals. The degreeof distortion may range from the negligible to the significant. This is in direct contradictionto the efficient market hypothesis, which maintains that market prices accurately reflect all theavailable information.

Second, instead of playing a purely passive role in reflecting an underlying reality, financialmarkets also have an active role: they can affect the so-called fundamentals they are supposedto reflect. That is the point that behavioral economics is missing. It focuses only on one half of areflexive process: the mispricing of financial assets; it does not concern itself with the impact of themispricing on the so-called fundamentals.

There are various pathways by which the mispricing of financial assets can affect the socalledfundamentals. The most widely travelled are those which involve the use of leverage—both debt and equity leveraging. The various feedback loops may give the impression thatmarkets are often right, but the mechanism at work is very different from the one proposed bythe prevailing paradigm. I claim that financial markets have ways of altering the fundamentalsand that may bring about a closer correspondence between market prices and the underlyingfundamentals. Contrast that with the efficient market hypothesis, which claims that marketsalways accurately reflect reality and automatically tend towards equilibrium.

My two propositions focus attention on the reflexive feedback loops that characterizefinancial markets. There are two kinds of feedback: negative and positive. Negative feedbackis self-correcting; positive feedback is self-reinforcing. Thus, negative feedback sets upa tendency toward equilibrium, while positive feedback produces dynamic disequilibrium.

Positive feedback loops are more interesting because they can cause big moves, both in marketprices and in the underlying fundamentals. A positive feedback process that runs its full courseis initially self reinforcing, but eventually it is liable to reach a climax or reversal point, afterwhich it becomes self reinforcing in the opposite direction. But positive feedback processes donot necessarily run their full course; they may be aborted at any time by negative feedback.

I have developed a theory about boom-bust processes, or bubbles, along these lines. Everybubble has two components: an underlying trend that prevails in reality and a misconception relatingto that trend. A boom-bust process is set in motion when a trend and a misconception positivelyreinforce each other. The process is liable to be tested by negative feedback along the way. If thetrend is strong enough to survive the test, both the trend and the misconception will be furtherreinforced. Eventually, market expectations become so far removed from reality that people areforced to recognize that a misconception is involved. A twilight period ensues during which doubtsgrow, and more people loose faith, but the prevailing trend is sustained by inertia. As Chuck Prince,former head of Citigroup said: we must continue dancing until the music stops. Eventually a point isreached when the trend is reversed; it then becomes self reinforcing in the opposite direction.