Not all bubbles involve the extension of credit; some are based on equity leveraging. The bestexamples are the conglomerate boom of the late 1960s and the Internet bubble of the late 1990s.

When Alan Greenspan spoke about irrational exuberance in 1996 he misrepresented bubbles.

When I see a bubble forming I rush in to buy, adding fuel to the fire. That is not irrational. And thatis why we need regulators to counteract the market when a bubble is threatening to grow too big,because we cannot rely on market participants, however well informed and rational they are.

Bubbles are not the only form in which reflexivity manifests itself. They are only the mostdramatic and the most directly opposed to the efficient market hypothesis; therefore they deservespecial attention. But reflexivity can take many other forms. In currency markets, for instance, theupside and downside are symmetrical so that there is no sign of an asymmetry between boom andbust. But there is no sign of equilibrium either. Freely floating exchange rates tend to move in large,multi-year waves.

The most important and most interesting reflexive interaction takes place between the financialauthorities and financial markets. Because markets do not tend toward equilibrium they are proneto produce periodic crises. Financial crises lead to regulatory reforms. That is how central bankingand the regulation of financial markets have evolved. Both the financial authorities and marketparticipants act on the basis of imperfect understanding, and that makes the interaction betweenthem reflexive.

While bubbles only occur intermittently, the interplay between authorities and markets is anongoing process. Misunderstandings by either side usually stay within reasonable bounds becausemarket reactions provide useful feedback to the authorities, allowing them to correct their mistakes.

But occasionally the mistakes prove to be self-validating, setting in motion vicious or virtuouscircles. Such feedback loops resemble bubbles in the sense that they are initially self reinforcing, buteventually self defeating.

It is important to realize that not all price distortions are due to reflexivity. Marketparticipants cannot possibly base their decisions on knowledge—they have to anticipate thefuture, and the future is contingent on decisions that people have not yet made. What thosedecisions are going to be and what effect they will have cannot be accurately anticipated.

Nevertheless, people are forced to make decisions. To guess correctly, people would haveto know the decisions of all of the other participants and their consequences, but that isimpossible.

Rational expectations theory sought to circumvent this impossibility by postulatingthat there is a single correct set of expectations and people’s views will converge around it.

That postulate has no resemblance to reality, but it is the basis of financial economics as it iscurrently taught in universities. In practice, participants are obliged to make their decisions inconditions of uncertainty. Their decisions are bound to be tentative and biased. That is thegeneric cause of price distortions.