The Intrinsic Instability of Financial Markets

Abstract: In this paper we explain the wild fluctuations of financial prices from the intrinsic amplifying feedback of speculative supply and demand. Formally, we show that an asset return follows a multiplicative random growth with exogenous input, which is well-known to be a generic power-law generating process, and which could thus easily explain the well-established power-law distribution of returns, and other related variables. Moreover, the theory we develop here is a general framework where competing ideas can be discussed in a unified way. The dominant random walk model, for instance, is easily derived in this framework if we superimpose market clearing (central to neoclassical economics). It corresponds to the case where the feedback in price dynamics is ignored in favor of the external input, namely the random inflow of news from the real economy.