Occasionally, the price distortions set in motion a boom-bust process. More often, they arecorrected by negative feedback. In these cases market fluctuations have a random character. I comparethem to the waves sloshing around in a swimming pool as opposed to a tidal wave. Obviously, thelatter are more significant but the former are more ubiquitous. The two kinds of price distortionsintermingle so that in reality boom-bust processes rarely follow the exact course of my model. Bubblesthat follow the pattern I described in my model occur only on those rare occasions where they are sopowerful that they overshadow all the other processes going on at the same time.

It will be useful to distinguish between near equilibrium conditions, which are characterizedby random fluctuations, and far-from-equilibrium situations where a bubble predominates. Nearequilibrium is characterized by humdrum, everyday events which are repetitive and lendthemselves to statistical generalizations. Far-from-equilibrium conditions give rise to unique,historical events where outcomes are generally uncertain but have the capacity to disrupt thestatistical generalizations based on everyday events.

The rules that can guide decisions in near equilibrium conditions do not apply in far-fromequilibriumsituations. The recent financial crisis is a case in point. All the risk managementtools and synthetic financial products that were based on the assumption that price deviationsfrom a putative equilibrium occur in a random fashion broke down, and people who relied onmathematical models which had served them well in near-equilibrium conditions got badly hurt.

I have gained some new insights into far-from-equilibrium conditions during the recentfinancial crisis. As a participant I had to act under immense time pressure, and I could not gatherall of the information that would have been available—and the same applied to the regulatoryauthorities in charge. That is how far-from-equilibrium situations can spin out of control.

This is not confined to financial markets. I experienced it, for instance, during the collapseof the Soviet Union. The fact that the participant’s thinking is time-bound instead of timeless isleft out of the account by rational expectations theory.

I was aware of the uncertainty associated with reflexivity, but even I was taken by surpriseby the extent of the uncertainty in 2008. It cost me dearly. I got the general direction of themarkets right, but I did not allow for the volatility. As a consequence, I took on positionsthat were too big to withstand the swings caused by volatility, and several times I was forcedto reduce my positions at the wrong time in order to limit my risk. I would have done betterif I had taken smaller positions and stuck with them. I learned the hard way that the range ofuncertainty is also uncertain and at times it can become practically infinite.

Uncertainty finds expression in volatility. Increased volatility requires a reduction in riskexposure. This leads to what Keynes calls increased liquidity preference. This is an additionalfactor in the forced liquidation of positions that characterize financial crises. When the crisisabates and the range of uncertainty is reduced, it leads to an almost automatic rebound in thestock market as the liquidity preference stops rising and eventually falls. That is another lessonI have learned recently.

I need to point out that the distinction between near and far equilibrium conditions was introducedby me while trying to make some sense out of a confusing reality, and it does not accurately describereality. Reality is always more complicated than the dichotomies we introduce into it. The recentcrisis is comparable to a hundred-year storm. We have had a number of crises leading up to it. Theseare comparable to five or ten-year storms. Regulators who had successfully dealt with the smallerstorms were less successful when they applied the same methods to the hundred-year storm.

These general remarks prepare the ground for a specific hypothesis to explain the recentfinancial crisis. It is not derived from my theory of bubbles by deductive logic. Nevertheless,the two of them stand or fall together.