ABSTRACT
Financial instability is one of the most pressing problems of our time and is affected by a complex nexus of fi nancial, economic and political forces. From the 1960s onwards, standard approaches focused increasingly on assumptions of rational expectations and effi cient fi nancial markets (Muth 1961; Fama 1965). The actions of homogeneous, independent, selfinterested individuals were assumed to be coordinated effectively via the ‘invisible hand’ of the price mechanism. Traders were assumed to use information effi ciently, systematically and consistently, forming expectations rationally by avoiding systematic mistakes. Asset prices would equilibrate towards the true fundamental values, where the fundamental value is defi ned as the discounted stream of expected future returns: for example, in the case of a stock/share this is the discounted stream of expected future dividends. Given the liquid, fastmoving nature of fi nancial markets, it was also assumed that speculative noise trading would have no signifi cant impact because arbitrage would eliminate it and asset prices would adjust fully to refl ect all currently available information. Allowing for differences in risk across assets, an asset’s price was assumed to be an unbiased indicator of its fundamental value given its risk profi le.
