Implausible Equilibrium Solutions in Economics and Finance

Models that admit only equilibrium solutions are prevalent in neoclassical economics and modern finance. Such solutions lack path dependence and evolve only in reaction to exogenous changes but, worryingly, the stability of these solutions and the nature of any non-equilibrium alternatives are rarely considered. We describe how such equilibrium solutions, and the modeling assumptions underpinning them, can be ‘stress-tested’ by embedding the models within more general agent-based frameworks that are capable of endogenous, non-equilibrium, dynamics. This procedure is applied to the geometric Brownian motion description of asset prices which serves as our prototypical equilibrium model. The introduction of a simple, yet plausible, form of coupling between the agents results in endogenous fluctuations that destabilize the Brownian equilibrium solution. These fluctuations typically consist of long periods of gradually increasing mispricing followed by extremely rapid reversals. Importantly, this occurs at realistic coupling strangths and is consistent with the observed price dynamics of real markets. The methodology and results are presented within the context of an asset pricing model but we shall argue that the ‘boom-and-bust’ character of the destabilizing endogenous dynamics is likely to be present more generally in economic systems. Finally we demonstrate the links between this modeling approach with Soros’ theory of reflexivity and Minsky’s theory of financial instability. JEL Classification: C62; D01; D03; D50; D53