Reflexivity, Coherent Markets, and Financial Instability:

Reconsidering Alternative Explanations for Departures from Generally Accepted Economic and Financial Theory

J. Douglas Barrett
Professor of Quantitative Methods and Chair
Department of Economics and Finance
University of North Alabama
Florence, AL 35632
jdbarrett@una.edu

Peter M. Williams
Professor of Economics
Department of Economics and Finance
University of North Alabama
Florence, AL 35632
pmwilliams@una.edu


ABSTRACT

The current financial crisis has caused a reassessment of many canonical assumptions underpinning traditional theory in economics and finance.  Specifically, the real estate and financial markets have exhibited behavior that belies previously expected conditions.  Nonstandard theories have existed for decades, but have been largely ignored by mainstream academia.  The Reflexivity Theory of Soros, the Coherent Markets Hypothesis of Vaga, and the Financial Instability Hypothesis of Minsky are three potentially viable theories.  The current work is an investigation of these and other alternative theories in economic and financial analysis.


INTRODUCTION

Traditionally, the dominant school of thought in finance is the Efficient Market
Hypothesis (EMH).  (See, e.g., [3].)  In its simplest form, the EMH asserts that market prices reflect all available information.  Theoretically based in mathematics, the EMH is the foundation for much of the inquiry in the discipline.  Empirical studies have shown results that are, at best, mixed.  The recent economic crisis has exacerbated the situation.

The EMH is based on several assumptions.  It asserts that past information does not affect market activity (i.e., the process is “memoryless”), once this information is generally known.  Another assumption is that capital market behavior follows a “random walk.”  Furthermore, with a sufficiently large sample, the returns become well approximated by a normal (Gaussian) distribution.

The purpose of the current study is to discuss issues with the EMH, and highlight the current alternative theories.  In the next section, empirical departures from the aforementioned assumptions for the EMH are discussed.  The succeeding section highlights the list of alternative theories, with a brief description of each.  The paper concludes with a summary and points of convergence for the competing theories.  ...

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http://rwahlers.iweb.bsu.edu/abd2009/Papers/p09_barrett_williams.pdf