CHAPTER 1Microeconomic Perspectives: TO EQUILIBRIUM OR NOT?
The most interesting, and profitable, times to be involved in investment management are when Mr. Smith's invisible hand is visibly broken.
—Paul A. McCulley
In this opening chapter, we begin our discussion of the various lenses that prove useful in the study of booms and busts by focusing upon a critically important and far-reaching element of traditional microeconomic theory: supply and demand–driven equilibrium. Two competing and seemingly contradictory theories are presented and discussed: the efficient market hypothesis and the theory of reflexivity.
There are many ways in which to illustrate the concept of equilibrium, but it is perhaps best analogized with a ball on a curved shape (see Figure 1.1). A situation in which equilibrium is possible is one in which over time, if left to its own devices, the ball will find one unique location. Overshooting or undershooting this spot is self-correcting. A situation of disequilibrium, however, is one in which the ball is unable to find a unique location. A ball in such a state does not generate self-correcting moves that dampen its moves toward a theoretical “equilibrium” or resting spot; rather, disequilibrium generates motion that is self-reinforcing and accelerates the ball's move away from any stable state.
Figure 1.1 Equilibrium in Pictures
The application of ...